Half of U.S. stocks are in a bear market as the market faces a 'crossroads'

Original author: Dong Jing

Source: Wall Street Journal

U.S. stock indices are hovering near all-time highs, but the market internals have quietly diverged.

Morgan Stanley’s chief equity strategist, Mike Wilson, issued a warning in his latest report: there is currently a roughly 12% divergence between the breadth of the U.S. stock market and index prices—a discrepancy that must be resolved one way or another: either the indices will decline to align with market breadth, or bond volatility will subside and broad-based stock rallies will push indices higher. The two paths lead in opposite directions, and the ultimate arbiter is just one: the U.S. bond market.

Currently, 51% of Russell 3000 components have declined more than 20% from their June highs, officially entering bear market territory; the median stock in the S&P 500 is 16% below its 52-week high, and market breadth has fallen to its lowest level since the dot-com bubble burst. Meanwhile, the 10-year U.S. Treasury yield has returned to 5.25%, the MOVE index, which measures Treasury volatility, has surpassed 100, while the “fear gauge,” the VIX stock market volatility index, remains below 15—a rare divergence between equity and bond volatility that has raised significant market警觉.

Wilson's conclusion is: If bond volatility remains elevated, the S&P 500 may decline to a range of approximately 6,800 to 7,300 over the next month before potentially rebounding year-end; if bond volatility cools first, a catch-up rally in individual stocks could drive both the index and market breadth higher.

On the surface, the S&P 500 is still trading near all-time highs, but the internal damage within the market has become quite severe.

Wilson noted in the latest Weekly Warm-up report that 51% of Russell 3000 components have declined more than 20% from their June highs, worsening from "over 40%" two weeks ago. Meanwhile, the S&P 500’s forward P/E ratio has retreated to approximately 19x, matching its low point during the height of the Iran conflict in March.

Looking at industries individually, the distribution of losses is highly uneven. In the semiconductor sector, 96% of stocks have declined more than 20% from their June highs, with 69% falling more than 40%; in the automotive sector, 71% of stocks have dropped over 20%, and every single automotive stock has declined by at least 10%; in the software sector, this proportion stands at 75%. The banking sector is an exception, with only 4% of stocks experiencing a pullback of similar magnitude.

Wilson classified the aforementioned sectors in distress as "classic early-cycle winners"—semiconductor and automotive stocks significantly outperformed the market from the rolling recession trough in April 2025 to June 2026, but Morgan Stanley had already signaled in June that the breadth of earnings revisions for these early-cycle winners had peaked, indicating the market is transitioning from early-cycle to mid-cycle, with quality factors beginning to dominate. The Fed’s hawkish pivot is another classic signal of this cycle transition.

Goldman Sachs’ data further supports this assessment. According to Goldman Sachs TMT strategist Peter Callahan, the median stock in the S&P 500 is currently 16% below its 52-week high, and market breadth has fallen to its lowest level since the dot-com bubble burst. Goldman Sachs warned as early as May 1 that the sharp decline in breadth "has historically preceded above-average drawdowns in the S&P 500 over the subsequent 6 to 12 months," and five months later, this indicator continues to deteriorate.

The deterioration in market breadth did not happen overnight, and Wilson's clarification of the timeline is particularly crucial.

Over the summer, the percentage of S&P 500 components trading above their 200-day moving average rose from 59% at the end of May to around 75%, even as oil prices and U.S. Treasury yields rose simultaneously, indicating broadening market strength. However, this trend reversed sharply after the Jackson Hole Global Central Bank Meeting in late August, and the current percentage has fallen to 49%.

Wilson explicitly stated that the sudden narrowing of breadth was not triggered by rising oil prices, but rather by the market beginning to digest a more hawkish Federal Reserve path following Jackson Hole.

A similar shift is clearly visible in the interest rate market. Rising nominal GDP growth and higher energy prices drove yields higher in the first half of the year, but since late August, further yield increases have increasingly reflected the Fed’s hawkish pivot—this pivot occurring against a backdrop of strong economic growth, which is not necessarily bad for the broader stock market, but has indeed influenced the direction of market leadership.

Statistics from BTIG strategist Jonathan Krinsky provide additional context: according to data cited by Bloomberg, there have been 57 trading days this year in which price and breadth moved in opposite directions, tying the highest record over the past 30 years, with still four and a half months remaining until year-end.

Wilson quantified the divergence between the current index and breadth as "a gap of approximately 12% relative to the S&P 500, which must be closed in some way."

However, despite the deterioration in market breadth, Morgan Stanley and Goldman Sachs have rarely agreed on fundamental assessments: the current market weakness is not due to deteriorating fundamentals, but rather the result of valuation compression.

Wilson noted that the S&P 500’s EPS revision breadth is 25%, significantly higher than the 7% for the lower-quality Russell 2000, with the median stock’s EPS growth rate sitting in the middle of a range of several percentage points. “The index has stood still since early June not because earnings have stalled, but because valuations have absorbed the shock.”

According to Bloomberg, citing Goldman Sachs data, S&P 500 EPS grew 51% year-over-year in Q2, and the forward P/E ratio has declined from approximately 23x to about 19x; Goldman Sachs’ 12-month target price of 8,700 assumes almost no contribution from multiple expansion.

Notably, Morgan Stanley’s 2026 EPS forecast of $339 is about 6% below the bottom-up market consensus of $361—even this strategist, who insists that “earnings are carrying the load,” has a forecast significantly below the market consensus.

Wilson attributes the current situation to two scenarios, and the distinction between them hinges entirely on whether U.S. Treasury volatility can cool down.

Scenario 1: If bond volatility remains elevated, market breadth and index prices will "meet in the middle" over the next month, implying a potential 6% pullback for the S&P 500, corresponding to an index level of approximately 7,300, followed by a strong year-end rebound.

Scenario 2: If bond volatility stabilizes first, stock breadth will catch up to index prices, driving both higher.

Wilson has long viewed 4.50% as the critical level at which the 10-year U.S. Treasury yield exerts substantial downward pressure on equity valuations. After the 10-year U.S. Treasury yield breached this level in May, the S&P 500’s forward P/E ratio continued to decline. As of last Friday, the 10-year U.S. Treasury yield returned to 5.25%, erasing all of its gains following the non-farm payrolls data release.

The MOVE index, which measures U.S. Treasury volatility, has now surpassed 100, while the VIX remains below 15. Wilson notes, "The calmness of the VIX during the recent collapse in breadth and valuation is striking," and highlights this anomalous divergence with a red question mark. He believes that whether and when equity and bond volatility will synchronize will ultimately determine how the gap between breadth and indices is closed.

Notably, Wilson specifically addressed the impact of the new Federal Reserve Chair, Walsh, on market pricing in the report.

Since Jackson Hole, the 2-year U.S. Treasury yield has risen nearly 60 basis points, with markets interpreting the signal from Powell as indicating that inflation must not only decline but do so “quickly enough.” The September rate hike further reinforced this reaction function.

However, Wilson believes the bond market may have overreacted. “In our view, the bond market has recently shifted to an overly hawkish stance.” He also noted that term premiums are currently performing well, which somewhat alleviates concerns about fiscal sustainability or the Fed being significantly behind the curve.

More importantly, Wilson offered a unique interpretation of Fed Chair Walsh's monetarist stance:

The market may be overestimating the number of rate hikes expected over the next year while underestimating Waugh’s willingness to use his balance sheet to finance deficits or stabilize financial conditions at the first sign of trouble. Our view is that Waugh will ultimately provide liquidity when necessary, but the market may wish to test his resolve first. The recent rise in yields and bond volatility is a step in that direction.

In other words, the "wash put option" objectively exists, but the strike price remains unclear, and the market appears to be actively seeking this price.

At this stage, Wilson recommends sticking with large-cap quality stocks, particularly asset-light companies with consistently improving earnings revisions, and focusing on quality and operational efficiency factors such as high free cash flow yield, low accruals, and high sales per employee.

If the index does indeed experience a pullback, completing the "adjustment that has been underway beneath the surface for months," Wilson believes it will be the time to increase positions in higher-risk stocks, with a window of opportunity expected within the next month.

In the context of AI, Morgan Stanley analyst Michelle Weaver’s sixth AI mapping analysis of approximately 3,600 global stocks shows the market is rotating from "AI enablers" to "AI adopters." Market consensus expects highly relevant AI adopters to achieve a 4.6% expansion in EBIT margin between 2025 and 2026, outperforming the broader S&P 500; however, this advantage nearly disappears in longer-term forecasts, indicating that analysts have already priced in the initial AI upside but have not fully accounted for its sustainability.

At the valuation level, the next 12 months' EPS for highly relevant AI adopters has risen approximately 70% over two years (with enablers more than doubling), yet median adopters are currently trading at a forward P/E of just 18x, in line with the MSCI World Index and significantly below the 22x of enablers.

Additionally, companies with AI at the core of their investment logic outperformed those with only marginal importance by 107%; meanwhile, companies facing a core AI threat underperformed those facing a mild impact by approximately 161%, indicating that markets are increasingly refining their pricing of AI’s impact.