Yesterday, we got a 3.0% inflation reading, which was a touch below expectations. Markets responded about as you might expect.

The tomb is sealed, and we don’t even realize it yet.

Bottoms are made on panic. Tops are made on euphoria. In October, we were fearing hyperinflation. Now there is open discussion about deflation.

The truth is always somewhere in between.

I’ll get to the point: I think that stocks have peaked in the near term, and I think that we could have a correction of 10%–12%. That may not sound like much, but it will come as a surprise to a lot of people, and things will get pretty bumpy.

We went from believing that inflation was undefeated to defeated in nine months. Over that time, the stock market has rallied over 20%. There is a lot of complacency out there. It’s the summer, people are having a good time, and they don’t see the need to hedge. People aren’t doing a lot of thinking about how to insure against a downturn.

Mind you, I’m not talking about a crash—I would never call for a crash—I’m just saying that a sharp correction is highly likely, and it is going to catch a lot of people offside.

Think Objectively About Sentiment
Market sentiment is heating up—something I just talked about recently with Ed D’Agostino (watch here if you missed it). People are pretty happy right now. I am pretty happy right now. There are a lot of good things going on in my life. I graduated last month, I’m writing short stories, I’m writing essays, I’m productive and peaceful, and I’m getting back in the gym—life could not be better.

One of the things about sentiment trading is stepping outside yourself to think objectively about sentiment—including your own sentiment.

In October of last year, I was not that happy. I was overworked, not getting any exercise, and I was staring down the barrel of paying for this new palace of a house while the value of my portfolio was down about 10%. I stepped outside myself, examined my own sentiment, and observed sentiment in others.

There are indicators. You can look up the AAII numbers, and you will see that we’re in bullish sentiment territory. You can see the retail flows that are going into the market. Retail is always the last to know.

Now, I don’t think we come anywhere near putting in new lows, as the lows in October were a generational sentiment bottom. You had people predicting not just a crash in stocks but nuclear war and other horrible things. It was nuts. I think we will get down to about 4,000 in the S&P 500. And if we don’t, great!

And if you don’t believe me, then at least do some prudent risk management—go through your portfolio and figure out what you really need and what you really don’t need. Maybe think about a hedge. Maybe think about building the cash position. Nobody wants to do that, though, because of fear of future regret. They’re afraid that they’ll miss out on gains, which most people find to be worse than experiencing losses.

A Disinflationary Impulse
I do think inflation will get down to 2% or so. Whether or not the Fed stops hiking rates is another issue altogether because of the politics, optics and interpersonal dynamics at the Fed. But I do think it will pause soon, and I do think the yield curve will un-invert. I also think that short-term rates will come down a lot, and long-term rates will come down, too.

Speaking of sentiment, sentiment on bonds is very negative. If you look at the CFTC Commitment of Traders reports, speculators have never been shorter five- and 10-year note futures.

I talked about this in The Daily Dirtnap the other day—former New York Fed President Bill Dudley recently laid out his case for higher rates in the future. Bill Dudley is many things, but he is not a trader. I read his piece in Bloomberg Opinion. For a guy who is ostensibly as smart as he is, it was 1,000 words of linear thinking—the type of thinking that gets you in trouble.

Markets do what we least expect them to. That is the nature of markets. When it makes all the sense in the world for rates to go up, that is usually the point at which rates go down.

In case you haven’t noticed, we are in the midst of a disinflationary impulse. I think inflation will settle out around 2%, but what if it goes lower? How will the Fed react, then? To be determined. Kind of hard to make the argument that you still need to keep tightening, but as long as inflation is above the 2% target, I suspect the Fed will try.

But yesterday was the day that we declared victory over inflation. Try this: Look up the date when the U.S. killed Osama Bin Laden and plot that on a chart of the S&P 500…

Then see what happened next. That’s what happens when you declare victory over things.

Jared Dillian is the editor and publisher of the Daily Dirtnap. An investment strategist at Mauldin Economics, he is author of All the Evil of This World. He may have a stake in the areas he writes about.