There are two different stock market realities, says Schwab’s chief investment strategist, Liz Ann Sonders: There’s the perception of the market’s strength and the truth about what has happened to the bulk of the companies in the S&P 500 and Nasdaq this year.

Sonders warned advisors about these trends at Schwab’s Impact conference on Tuesday.

“In fact, there has been lots of chatter about how resilient the market has been this year, but a look under the hood is revealing,” said Sonders. “More than 90% of the S&P and Nasdaq has had at least a 10% drawdown this year, with the average being minus 18% for the S&P and—get this—a whopping minus 38% for the Nasdaq.”

These are called rotational corrections, when different parts of the market rise and fall. They are certainly preferred over swift corrections across the entire index. Sonders warned, however, that while “this benign scenario could persist … I wouldn’t be surprised if indexes at some point play some catch-down.”

While most advisors recognize that the market is not cheap at this point, the surge in price-earnings denominators has helped bring multiples down from last year’s surge, she said.

“These days, I’m often asked if the market is in a bubble. And bubbles, we know, form when enough people shift their investment thesis from ‘Will I make money from holding this security or asset class and receiving its profits?’ to ‘Will I be able to find someone to buy this security or asset class at a higher price?’” Well that certainly applies to many of the speculation-fueled pockets, perhaps not yet to the broader market,” Sonders said.

So, what’s an investor to do? “First, keep a sharp eye on the correlation between bond yields and stock prices,” Sonders said.

During the inflationary period that persisted for three decades starting in the 1960s, yields and stock prices moved inversely. But in the years since then, amid the bursting of the housing and tech bubbles, yields and stock prices have moved together, she said.

Recently the correlation inverted for a short span. A more sustained inverse correlation could send a message that we’ve entered a secular period of higher inflation.

She said that given the extreme volatility, it might be time for investors to focus more on factors like quality rather than on traditional sectors and style buckets.

A “quality” factor could be a company’s positive earnings revisions representing a hybrid of growth and value, revisions that bring with them lower forward multiples, she said.

She also suggested rebalancing. “A strategy we’ve been suggesting for investors is to consider volatility-based versus calendar-based rebalancing, in the interest of adding into weakness and trimming into strength a more subtle form of buy low and sell high.”

Sonders said she’s been asking herself lately whether the Covid-induced recession launched a traditional economic cycle or instead interrupted one. Or perhaps it was something entirely different.

There are some late-cycle alarms that have been ringing lately, including the inflation backdrop of course, Sonders admitted. “The key question is whether Covid’s toxic brew and its impact on supply chains is a setup for 1970s style stagflation? In short, there are more differences than similarities. The purest definition of stagflation includes high and rising unemployment, clearly in contrast to today’s extremely tight labor market. While productivity is much stronger today as well.”

Secular forces tend to shift and create either a prevailing inflationary or deflationary backdrop, “but psychology also comes into play, when the psyche of workers and companies changes and each decides they can use their power to demand higher wages, pass on higher costs persistently. That’s when the so-called wage-price spiral kicks in,” she said.

There are two broad categories of inflation. Pro-cyclical inflation occurs when stronger economic activity drives prices up. Countercyclical inflation occurs when high prices drag economic activity down, Sonders explained.

“I think the risk is that we have shifted from pro-cyclical to countercyclical inflation. For now, we have moved from an age of abundance to an age of scarcity. Interdependencies, low inventories across global supply chains have created a pretty fragile system that’s become more vulnerable to shocks and their ripple effects, including the global energy crisis,” she said.

So what will the Federal Reserve Bank’s reaction be? “We all know that the central bank’s policy tools can do little to ease bottlenecks in the global supply chain, but a risk is that the Fed will have to tighten policy more quickly than anticipated to quell demand,” she said.

Perhaps a more benign scenario is that high prices cure high prices with lower demand. “In other words, might inflation protect us from the Fed before the Fed feels it has to protect us from inflation?” Sonders asked.

Clearly, the Fed’s ongoing promise of liquidity has had an important psychological impact on equity investors, and this is why concerns about the coming tapering remain front and center. “The reality, though, is that the growth rate of liquidity peaked in February. Not coincidentally, many of the market’s most significant drawdowns began at that inflection point. Certainly, that was the case among the speculation-fueled non-traditional market pockets,” Sonders added.