The Stock Market’s Bad Breadth

Mike Wilson (0:00)

Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and Chief US Equity Strategist. Today on the podcast, I'll be discussing the market's bad breath. It's Monday, September 28th at 1130 a.m. in New York. So let's get after it.

The market is up this year, that's the good news. But over the last six weeks, I've been watching something that's giving me pause. This rally has been carried by a shrinking group of stocks. More than half of the Russell 3000 is at least 20% below its June highs, and the S&P 500 forward multiples fall into 19 times, close to a new low for the year. Meanwhile, earnings growth is still running in the mid-teens for the median stock, and revisions breadth is approaching cycle highs for the S&P 500 That's not complacency. It's a market that has already done a lot of work to price higher energy costs, a tighter Fed, AI disruption, questions around returns on capital, and geopolitical risk.

Last week in the podcast, I noted that this is classic mid-cycle behavior. Earnings are absorbing lower valuations, and quality is taking the baton from early cycle winners. Groups that have led powerfully from the rolling recession trough have been among the weakest areas recently, autos, semis, and short cycle industrials.

That's what tends to happen when the cycle ensures and the Fed turns less friendly. The market stops paying for high beta and starts rewarding free cash flow, stable margins, operating efficiency, and earnings that are still being revised higher. That's why I continue to favor large cap quality, particularly asset light, services oriented, and fee based businesses. Having said that, there's still one problem to resolve. Breath improved through most of the summer, even as crude and yields moved higher. The deterioration came after Jackson Hole. That's when markets began discounting a more hawkish Fed reaction function. The percentage of S&P 500 stocks above the Tune or Day moving average fell from roughly 75% to below 50%, while the index held up much better. That divergence cannot persist forever. Either breath catches up to price, or the index comes down to meet breath. If bond volatility does not settle down soon, it could spill over into equity vol, and we would see the S&P 500 price come down about 5 or 10%.

Frankly, I would welcome it. A final index level correction is often how a multi-month correction beneath the surface ends. There's been a lot of focus on the Fed's recent pivot to rate hikes. However, the two-year yield is already above the level implied by the Fed's projections. To me, this suggests the bond market has been leaning too hawkish in the near term. The bigger uncertainty is how the new Fed chairman approaches liquidity in the balance sheet. He is more of a monetarist than his predecessors, and markets are still trying to understand what that means in practice. My expectation is that the Fed ultimately provides liquidity if financial conditions tighten too far, but markets may test that resolve first. Bond volatility, funding stress, and whether equity volatility follows are the key signals. If those pressures ease, breath can catch up and drive the market higher. If they do not, the index probably has more correcting to do.

There is also a new constructive story developing for investors. AI adoption is moving from promise to practice. Companies with higher AI adoption are seeing stronger margins and earnings trends, but consensus still assumes many of those benefits fade in the out years. We think that's too conservative. Productivity gains tend to compound, not immediately disappear. Earnings momentum is broadening from enablers to adopters, while adopter evaluations have reset to more attractive levels.

That supports a barbell approach, owned select enablers where earnings durability justifies the premium, but increasingly owned adopters where improving fundamentals are not yet fully reflected in expectations.

Bottom line, the market is not ignoring risk. It has priced the risk through lower valuations, weaker breath and major leadership rotations. What remains unresolved is the gap between a resilient index and a much weaker average stock. The answer is that we probably see breath improve and the index level come in before a surge to new all-time highs. That's why I still want to overweight large cap quality, but use October weakness to add to riskier stocks. The market may need one more uncomfortable adjustment, but that may be exactly what sets up a stronger finish to the year. I will be here to guide you.

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