The S&P 500 gained 8.2% during the quarter and has risen for five straight months. Value and dividend paying stocks performed best in the first half of the quarter (and for the year), but in June investors rotated back to the technology stocks that they favored in 2020 when COVID fears eased and rising inflation wasn’t on the radar.

Inflation is on the radar now. Why does inflation matter? SentimentTrader.com found that dating back to 1914 all of the market’s gain came when inflation was between 4% and negative 4%. But when inflation was higher than 4% the Dow lost 16%.

Will inflation spike to 4% or more? The Fed expects inflation to be “transitory” but initially investors saw record high inflationary statistics and feared the worst. That was then. Prices for some commodities have topped out and begun to fall (lumber was down 40% in June) and economic growth statistics will normalize over time. Note: the Fed never said what it considers “transitory.” A quarter? A year? Two?

I believe the spike in inflation is temporary and the bond market agrees. Why? The high inflation data show comparisons to a year ago when the economy was just beginning to open and prices were lower. Also, in time the market will adjust to supply issues.

Let’s take face masks as an example. Fourteen months ago you couldn’t find them in the stores. Now they are selling at a deep discount. When there is money to be made companies fill the demand. Over time the supply chain bottlenecks will be resolved. Inflation will recede as pent-up demand eases, spot shortages are resolved and catch-up buying will fill the store shelves and business inventories.

That said, I believe inflation is the market’s greatest risk. While I expect inflation will stabilize, a lot of very smart people that I respect disagree. For one, Wharton Professor Jeremy Siegel sees inflation as high as 5%. That would be a problem for stocks and bonds. We’ll keep watch.

The yield on the 10-year note surprised most analysts by falling roughly a quarter-percentage point in the second quarter. That’s good news for bonds and preferreds. The drop reflects growing doubts about how strong the economy will be in coming years.

Instead of a 1920s type of acceleration, the bond market expects the economy to grow at a healthy but sustainable pace in the coming years. Economists surveyed by The Wall Street Journal anticipate that the economy will grow 6.4% this year and then fall to 3.2% in 2022. I’ll take the over.

David Vomund is an Incline Village-based Independent Investment Adviser. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.