Don’t be fooled — inflation is a big risk for stock market investors. Here’s how to prepare

The government said June 10 that the cost of living surged in May and drove the pace of inflation to a 13-year high of 5%.

What should you do? Probably the opposite of what you are thinking. Before we get to that, here is a look at the two key events for stocks — in the bond market and at the Fed — between today and the end of the year.

Rising yields

Remember how the stock market freaked out earlier this year when the 10-year Treasury yield TMUBMUSD10Y, 1.472% moved up to around 1.7%? Well, expect a repeat. Only worse.

“We suspect that inflation in the U.S. will prove more persistent than investors currently appear to anticipate,” says Capital Economics economist Franziska Palmas, citing the tight labor market and wage growth. Her research group puts the 10-year yield at 2.25% by the end of this year, and 2.5% by the end of 2022.

That’ll be a big move from the current level of 1.5%. Stock investors tend to panic when interest rates rise a lot.

Fed tapering

Fed Chairman Jerome Powell has downplayed the need for tapering the central bank’s bond purchases to keep yields low. But half of the 12 members of the Federal Open Market Committee (FOMC) have recently said they’re ready to start talking about tapering. The FOMC is the Fed branch that sets monetary policy.

“It will be increasingly hard for Powell to claim the economy needs to make ‘substantial further progress’ toward achieving maximum employment before the Fed starts talking about talking about tapering,” says Ed Yardeni, author of Predicting the Markets and head of Yardeni Research. Powell has repeatedly said the Fed is awaiting “substantial further progress” in the economy before terminating its stimulus.

“Given the performance of the economy, it is reasonable to expect they will start to taper before end of year, and a few months later they will start to raise the federal funds rate,” predicts Yardeni.

He thinks the Fed will announce a decision to start tapering in its July meeting. Tapering refers to a reduction in bond purchases by the Fed. This tightens the money supply to put the brakes on growth. Once purchases go to zero, the Fed moves on to cutting rates.

As we know, tapering causes a “taper tantrum” in the stock market, meaning a sharp selloff in indices like the S&P 500 SPX, +0.00%, the Dow Jones Industrial Average DJIA, -0.08% and Nasdaq COMP, +0.08%.

How to prepare

When considering how to position for the probable selloff caused by rising bond yields and Fed tightening, the key things to remember is why these things are happening in the first place, and what history tells us about how stocks behave.

The consensus view is that tapering and rising bond yields kill off economic growth and the bull market in stocks. But this isn’t actually true.

Yes, initially, tightening can make stocks fall — or churn sideways, at best. But then stocks shake it off and move higher as the bull market continues. This makes sense, because the tightening is happening for good reasons that help companies — strong economic growth. This pushes earnings a lot higher, which resets valuations lower — back down to levels investors feel comfortable with.

“Tapering is part and parcel of a recovery,” says Leuthold market strategist Jim Paulsen. “It is a response to successful policy and a rebound in the economy. It is a natural part of the bull market that allows the market to go higher. It’s a healthy development.”

Looking through all the market fireworks that may lie ahead, Paulsen thinks underlying economic growth will push S&P 500 earnings up to $220 by the end of the year. Assuming the S&P 500 is at current levels or a little bit lower, that would bring the index’s price-to-earnings (P/E) ratio down to 18-19 — which is near or below the average since 1990. “That sets up the next leg of the bull market,” he says.

Your five-point game plan

1. Do not go to “defensives”

When people see stock market turbulence, the knee-jerk reaction is to go for the “stability” of defensive names like utilities and consumer staples. But that would be a mistake. You want to go to defensives when the economy is slowing or contracting, not when it is strong. Another problem is that defensive names pay yield. So, like bonds, they get hit by rising interest rates, which devalue dividends — and dividend-paying stocks and bonds.

“The best way to protect yourself is to tie your portfolio to the overheated economy. That is where the best profit growth and profit leverage is,” says Paulsen. “You do not get that with defensives.”

2. Go with companies that benefit from growth

Since rapid economic growth is causing the tapering — and the growth is usually not killed off by tightening — stocks linked to growth typically are the best place to be. This means cyclicals like industrials, basic materials consumer names, small-caps and international stocks. “Slower growth consumer staples and utilities won’t keep up with growth areas of the market,” says Paulsen.

I first suggested Lindblad Expeditions LIND, +0.91% and Cardlytics CDLX, +2.21% and in my stock letter, Brush Up on Stocks (the link to my site is in the bio, below) in September 2020 and November 2019. I still like and own both even though they are up 48% and 157% — or two to four times the S&P 500. Recent insider buying confirms they are buys and holds around current levels. Plus, both are cyclical names. Cardlytics helps credit card companies understand customer buying patterns for marketing purposes. Lindblad offers specialized cruise adventures to exotic locales. Both benefit from economic growth that powers more consumer spending.

3. Do not get out of stocks

If you think a selloff is coming, it might be tempting to try to get out of stocks right before that, to buy back after the weakness happens. But this is a lot harder than you think. In fact, it is almost impossible to get the timing right, say market veterans.

“You have to make two smart decisions,” says Yardeni. “You have to get out just before the correction and then you have to decide when to get back in. I don’t know of too many people that can do that consistently.”

Market timers often get out and don’t get back in, and they miss the next leg up. “You can get yourself into trouble trying to avoid the correction,” says Paulsen.

4. Do not own bonds

Bond yields will be 2% or higher by the end of year. So don’t own bonds, whose prices fall when yields rise — unless you simply plan to hold to maturity to collect the income.

5. Go with financials

Strong economies typically make the yield curve more upward sloping, meaning that long-term interest rates on 10-year Treasuries rise a lot faster than short-term interest rates. Since banks borrow at the short end and lend at the long end, steepening yield curves help them.

The strong economy will also help banks release reserves and lower provisions for loan losses, both of which can boost earnings, points out Yardeni. Both JPMorgan Chase JPM, -0.34% and Bank of America BAC, +0.18% are up over twice as much as the S&P 500 since I suggested them in my stock letter last August. But they still look attractive. Recent pattern buying by smart insiders among smaller banks confirms the sector is still one to own, despite the strength over the past few quarters.

Michael Brush is a columnist for MarketWatch. At the time of publication, he owned CDLX, LIND and BAC. Brush has suggested CDLX, LIND, JPM and BAC in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.