Observing the market sell-off today, I was reminded of a warning from legendary investment guru Sir John Templeton:

Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.

Stock market indices sharply fell today, as investors lost their euphoric affection for momentum technology stocks. The sell-off was broad based and gained velocity during the final 30 minutes of trading. All S&P 500 sectors finished lower.

Large-cap tech stocks led losers, with all five of the FAANG coterie closing deeply in the red. Facebook (NSDQ: FB), Apple (NSDQ: AAPL), Amazon (NSDQ: AMZN), Netflix (NSDQ: NFLX), and Alphabet (NSDQ: GOOGL), parent of Google, declined 4.13%, 4.63%, 6.15%, 8.38%, and 4.63%, respectively.

The Dow Jones Industrial Average posted its biggest drop since April 6, the S&P 500 fell for its fifth consecutive session, and the tech-heavy Nasdaq is now down 7% from its all-time high. The small-cap Russell 2000 fell 2.86%.

Alibaba (NYSE: BABA) tumbled 5.80% after analysts cut profit projections for the China-based e-commerce giant, citing softer Chinese growth due to trade conflict. Chipmakers also got caught in the rout. Bellwethers Advanced Micro Devices (NSDQ: AMD) and Intel (NSDQ: INTC) fell 8.22% and 3.76%, respectively.

The CBOE Volatility Index (VIX) soared 36.93% and now stands at its highest level since April 11.

Spooking investors were a host of factors, chief among them signs that inflation is a worsening threat.

The Bureau of Labor Statistics reported today that the Producer Price Index (PPI) increased 0.2% in September, the first monthly rise in the PPI since June. Economists expect the PPI to advance 2.8% year-over-year in 2018.

A closely watched measure of underlying producer price pressures that excludes food, energy and trade services, the so-called “core” PPI, increased 0.4% in September, the largest increase since January. In the 12 months through September, the core PPI rose 2.9%.

As inflationary fires grow hotter, the Federal Reserve is more likely to adopt an aggressive stance on raising interest rates. Rising rates already are taking their toll.

The Mortgage Bankers Association reported today that mortgage application volume fell 1.7% for the week. Volume was 15% lower compared with the same period a year ago. Rising interest rates are discouraging home buyers.

Other warnings signs are accumulating.

The International Monetary Fund asserted today that the escalating trade war poses grave risks to the global economy and could spark a financial crisis if combined with a further deterioration of emerging markets.

The yield on the 10-year Treasury note hovers above 3.17%, its highest level in more than five years. The 2-year yield exceeds 2.84%, its highest level since 2008.

CAPE Fear…

Not the 1991 thriller starring Robert De Niro. I’m referring to the cyclically adjusted price-to-earnings ratio (CAPE), my preferred valuation yardstick.

CAPE is giving off a bearish signal. You should fear it.

The widely respected (and uncannily prescient) Professor Robert Shiller of Yale University invented the CAPE ratio to provide a deeper context for market valuation.

The CAPE ratio is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation. The ratio currently stands at 31.59, nearly twice the historical mean of 16.57.

Shiller won the Nobel Prize for Economics in 2013, so he’s worth heeding. The CAPE ratio is illuminating whereas the traditional price-to-earnings (P/E) ratio can be misleading.

The key advantage of the CAPE ratio is that it eliminates the fluctuations in the traditional P/E generated by variations in profit margins during business cycles.

During economic expansions, companies rack up high margins and earnings; the traditional P/E ratio in turn becomes artificially low. The converse happens during recessions.

This long-term chart of the CAPE ratio is up-to-date as of today’s market close:

Source: Yale University

The CAPE ratio chart tells us that stocks in the S&P 500 have been partying like it’s 1929.

Earnings to the rescue?

Amid this sea of troubles, investors are expecting earnings to play savior. Third-quarter earnings season kicks off on Friday with a bevy of bank operating results. According to the latest Wall Street consensus, the S&P 500 is expected to report year-over-year earnings growth in the third quarter of 19.2%. That’s a strong showing, albeit below the 25% growth reported in the previous two quarters.

A major tailwind for earnings has been the 2017 tax cut package, but this stimulus is starting to wane. Ballooning public and private debt, trade conflict, rising interest rates, mounting inflation, political dysfunction, and geopolitical tensions are tipping the scales in favor of value over growth stocks.

As we saw today, overvalued momentum stocks, especially the mega-cap technology stars, are losing steam. They’re ceding their leadership position to value stocks in sectors more appropriate for the late stage of a recovery, such as industrials, consumer staples, energy, utilities, and health care.

During this protracted bull market, many investors have grown complacent. When volatility returns, they get taken by surprise and run for the exits. Don’t make the same mistake. Instead of panicking, methodically rotate toward the new market leaders. Base your decisions not on euphoria, but on logic.

Wednesday Market Wrap

• DJIA: 25,598.74 -831.83 (3.15%)
  
• S&P 500: 2,785.68 -94.66 (3.29%)
  
• Nasdaq: 7,422.05 -315.97 (4.08%)
  

Wednesday’s Big Gainers

• IDT (NYSE: IDT) +40.45%

Telecom drops dividend for buybacks.

• AcelRx Pharmaceuticals (NSDQ: ACRX) +35.66%

Biotech’s new pain med on verge of FDA nod.

• Esterline Technologies (NYSE: ESL) +29.99%

Aerospace/defense engineering firm targeted for buyout.

Wednesday’s Big Decliners

• Arbutus Biopharma (NSDQ: ABUS) -23.83%

Biotech’s hepatitis B drug encounters trial delay.

• Trinseo (NYSE: TSE) -20.79%

Materials maker misses on earnings.

• Karyopharm Therapeutics (NSDQ: KPTI) -20.08%

Biotech readies private debt offering.

Letters to the Editor

“What’s the consensus as to when the next recession hits?” — Paul D.

Most recoveries last about eight years; we’re now approaching the ninth year of expansion. Timing these events usually proves foolhardy, but most economists expect a significant downturn to hit sometime in 2019.

Comments or feedback? Drop me a line! You can reach me at: mailbag@investingdaily.com

John Persinos is the managing editor of Investing Daily.