Overview- The equity market continued its ascent during the first quarter, but it is showing signs of needing a pause to refresh. Below are the factors that may give the market a break from its current uptrend.

Valuation- While market valuations are expensive, valuation is rarely a harbinger of short-term changes in the market. Expensive valuations generally presage the possibility of muted future long-term returns. We believe it is unlikely that the equity market will be able to match the performance of the last 5-10 years over the next 5-10 years. The path to more moderate returns can take any of an infinite number of paths, both higher and lower, but rich valuations are a reminder that a balanced portfolio of both stocks utilizing all factors, size, domicile, and style – along with bonds – will provide a smoother ride than just large cap technology, which has been the driver for the past 4 years.

Economy- We see mostly positive economic signs. Most economic data we follow does not suggest that a quick slowdown is imminent. The personal savings rate, at a low 4%, is now at almost the all-time lows before the Great Financial Crisis in 2008. Personal Expenditures, as a result, are on the rise, and this is driving the economy higher. However, while we see signs of cracks in the economy such as rising bankruptcies, and credit card charge-offs, the overall economy is doing well. We can only surmise that this is evidence of a “K” economy where most are doing well, but there are signs that the bottom third of economic participants may be struggling. This will likely make future projections for the economy even more difficult than they have been over the last 2 years. An inverted yield curve has historically been one of the surest signs of economic weakness…until last year. A “K” economy where the strong get stronger and weak get weaker will continue to throw curve balls to economic pundits.

Inflation/Rates- This is now a clear negative and this is the biggest concern we have now for the equity markets. Federal Reserve officials felt, at the beginning of the year, that they would be cutting rates several times. It is now clear this was pure hope on their part. Inflation has become sticky at 3% and is not showing signs of abating to their 2% goal. The economy remains healthy, after all the rate hikes, and we would not be surprised that the Fed only cuts rates once this year or makes no cuts but they will face rising political pressure to cut rates. Longer-term rates are breaking important levels to the upside, and the trend is now up. This is a clear negative for the equity market, one that could bring about more downside volatility in the near term. Debt to GDP is now close to the highs of WWII. The government’s penchant for fiscal stimulus is being frowned upon by the bond market vigilantes and higher rates seem to be in the offing, mostly due to sticky inflation and continued fiscal irresponsibility.

Trend- We are still easily in a bull market as measured by most of our longer-term trend indicators, but there are signs that we are in front of a typical 5-15% pullback, which are not uncommon. While we still see bullish long-term signs, the short-term is a bit murky and we would not be surprised if the market was jumpy during Q2. Accordingly, we have adopted a slightly more defensive posture in both equities and fixed income, by raising cash and cutting duration, while the market sorts through current earnings and economic data.

Sentiment / Seasonality – This is still a bright spot in our work. We do not see the same signs of euphoria and greed that typically exist at the market tops. By this measure, it seems the market has room to move higher this year. Similarly, election years are often bullish for the market so both measures argue against a new bear market and suggest the market may continue to move higher after a moderate pullback.

Conclusion- 2Q should be a pause in the bull market as interest rates move up and market participants reassess how dovish the Fed will really be this year.