How Worried Should You Be? Traders Confront Inflation's Reality

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For almost a decade, investors have waited patiently for any hint of inflation in the U.S. economy, a sign the recovery can sustain itself without emergency stimulus from the Federal Reserve. Now they’re getting it, and many are shocked at the reaction.

It landed last week with the worst stock market plunge since January 2016. A stronger-than-expected employment report with signs of strengthening wage growth sent the Dow Jones Industrial Average down 666 points on Friday, bringing its five-day loss to almost 1,100 points. Share volatility surged.

Accounts of how concerned investors should be ran the gamut, from confidence traders will rush in and buy the dip, to warnings this time is different — that selloffs that begin in the bond market have a habit of snowballing.

“It is now signaling, potentially, the end of this eight-year bull rally,” said Rich Weiss, chief investment officer and senior portfolio manager of multi-asset strategies at American Century Investments. The firm manages $179 billion. “The Fed is going to have to move the interest rates, the bond market is recognizing that this incremental economic growth will spur on inflation from various sources.”

Little escaped the selloff. All 11 industries in the S&P 500 tumbled, a coordinated plunge that hadn’t happened since the month of Donald Trump’s election. Yields on 10-year Treasuries surged as much as 6 basis points Friday to 2.85 percent, the highest in four years. Oil dropped and the Bloomberg Commodity Index capped its biggest weekly slide in two months.

Of all the threats, surging Treasury rates and their implications for inflation are vexing investors the most, with this year’s half-percentage-point climb calling into question a valuation case on equities tied to how much more you get from corporate earnings than in bond interest. For last week, anyway, nobody seemed to care about the ostensibly positive signals coming from the bond market, the idea that higher yields bespeak rising demand for money among borrowers.

“It’s kind of a strange time and we seem to be driven by a fear of what everyone wants, and that’s higher rates,” said Joe “JJ” Kinahan, the chief market strategist at TD Ameritrade. “Higher rates confirm a stronger economy, and the market was very afraid of that all week long. And that’s been a big reason for selling.”

Strategies that worked for years buckled in the rout. So-called short-volatility, in which traders bet that share turbulence will remain restrained, reversed, as Friday’s 29 percent spike in the Cboe Volatility Index on Friday triggered a 13 percent plunge in the ProShares Short VIX Short-Term Futures exchange-traded fund. About 27 million shares changed hands, the most since the Brexit vote.

An irony for bulls is that the selloff arrived amid one of the best rounds of corporate earnings upgrades ever seen in the S&P 500. Combined estimates for 2018 profits among companies in the index have gone from $145.90 a share on Dec. 15 to $156.20 on Friday, a rate of increase that is four times faster than any stretch since at least 2012, data compiled by Bloomberg show.

In theory, the increase should help assuage fear bred by charts of the U.S. stock market’s price-earnings ratio. Using profits from the last 12 months, companies in the S&P 500 are trading for 22.5 times income, a level that since the dot-com bubble burst is matched only during the aftermath of the financial crisis, when earnings were close to nothing.

Using 2018 estimates, on the other hand, stocks fetch a slightly sturdier multiple of 17.7, while going out to the 2019 forecast of $172.30 takes the P/E down to 16.

“During the core of earnings season, stocks almost always react to whatever their earnings announcements are, and broadly, earnings were positive,” Kate Warne, investment strategist at Edward Jones, said in an interview at Bloomberg’s New York headquarters. “But as investors worry about whether this is enough and whether it can continue, we’re likely to keep seeing stocks become more volatile.”

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