Summary

Volatility returned to the stock market this week after a period of calm. Stocks have been trading within a limited range without clear catalysts for further buying pressure. Technology stocks, which have been driving the market’s performance this year, are currently trading at high valuations. There are significant unresolved risks and uncertainties in the market. The Federal Reserve is expected to raise interest rates to over 5% next week due to slow credit tightening and higher-than-preferred inflation. The latest Core PCE inflation reading remained relatively unchanged at 4.6%, far from the Fed’s target of 2%. The fight over the debt ceiling is heating up, with Republicans passing a bill in the House to raise it but with spending cuts that Democrats are expected to oppose. This situation could lead to significant volatility during and after the negotiation process, similar to the 2011 debt ceiling crisis. The breadth of the stock market rally, representing the number of companies participating, has been steadily declining. The market appears both resilient and fragile, but the fragility is believed to be underestimated given the range-bound trading, diminishing breadth, and the presence of market-moving uncertainties. A fragile market increases the likelihood of sudden, sharp downturns, which can harm long-term portfolio returns.

Talking Points

Volatility returned this week after about a month off.
• Stocks remain range-bound in what we’re seeing as a no-man’s land.
• There are no readily-discernible catalysts to further buying pressure.
• Tech has led the market’s rise so far this year and is very expensive: currently trading at 25x forward
earnings.
• Risks and uncertainties are big and unresolved.
• The Fed will hike rates to over 5% next week.
• In this they really have no choice: credit has been slow to dry up (even with the regional banking
crisis) and inflation is still much higher than they would prefer to see.
• Last month’s Core PCE inflation reading (the measure the Fed pays most attention to) came in
relatively unchanged at 4.6%. Still a ways from the 2% the Fed would much rather see.
• The debt ceiling fight is just warming up.
• This week Republicans in the House passed a bill to raise the ceiling but with a host of spending
cuts that Democrats are certain to balk at. The ball is now in the Democrats’ court.
• If this fight is anything like 2011’s, we can expect significant volatility in both the run up to the
agreement and even after the ceiling is raised as markets digest the negotiated product.
• Meantime stock market breadth—the number of companies participating in this latest stalled rally—has been
declining steadily.
• The market is in a paradox: it is simultaneously resilient and fragile.
• We think that, given its range-bound trading and fading breadth (not to mention the market-moving
uncertainties), the fragility is currently being understated and underappreciated.
• Nothing is more harmful to long-term portfolio returns than sudden, sharp downturns. With a fragile market
the likelihood of such sell-offs is much higher.

Key Takeaways

Stocks range-bound. Resilient, yes. Fragile, yes.
⇒ Breadth is fading. The number of stocks participating in this year’s rally is dwindling.
⇒ Environment not conducive to stock outperformance: Fed raising short-term rates to over 5% next
Wednesday and keeping them there. Inflation elevated, stubborn.
⇒ Stagflationary data from Q1 GDP report: growth comes in at 1.1% (lower than expected), while GDP
prices came in at 4% (higher than expected and higher than the previous quarter).
⇒ Debt ceiling negotiations tentative following Republican House passage of bill to raise the ceiling
but with spending cuts that Democrats will refuse to go along with. Unstoppable force, immovable
object.

EXHIBIT 1 – BREAKING BREADTH

• The S&P 500’s year-to-date return is being propped up by a handful of mega-cap tech stocks. The rest…

EXHIBIT 2 – NASDAQ BREADTH ALSO FALLING

• While the Nasdaq’s YTD return continues to fly high—thanks also to the largest tech stocks—the number of
advancers as compared to decliners continues to fall. These lines will have to converge at some point.

EXHIBIT 3 – OVERALL MARKET SHOWING WEAKNESS

• While mega-caps have lifted the S&P, the equal weight measure of the total market is showing broad weakness.