The Most Dangerous Divergence in US Stocks: Ordinary Stocks Have Already Crashed—How Much Longer Can the AI Giants Hold Up?

US stocks are staging a rare internal rupture—the index stands unmoved, but beneath it lies a scene of devastation.

Morgan Stanley's chief equity strategist Mike Wilson warns in his latest report that tightening financial conditions are quietly doing part of the Federal Reserve's work, except that this shock is being absorbed disproportionately by ordinary stocks rather than by the handful of AI-centered giants. The 10-year Treasury yield has broken above 5.3%, the dollar has risen to a new high for this cycle, and oil prices remain elevated. Under the combined weight of these three pressures, Morgan Stanley's composite financial conditions index has jumped to roughly 1.4 standard deviations—a level that has been breached only a few times in the past 35 years, the last being in 2022 when the Fed was hiking rates by 75 basis points at every meeting. Meanwhile, Goldman Sachs has revised its expectation to one more rate hike at the October FOMC meeting.

The market's key fault line is now clearly visible: the S&P 500 equal-weight index has lagged the market-cap-weighted index by 6% over the past six months. In September, when the 10-year yield broke above 5%, the equal-weight index fell 5% in a single month while the market-cap-weighted index was nearly flat. Goldman Sachs' Tony Pasquariello holds partial reservations about the "breadth collapse" thesis, but acknowledges that the median S&P 500 constituent has fallen 15% from its 52-week high—the worst reading since the dot-com bubble burst. The disagreement between the two institutions precisely outlines the market's most central question right now: how will this divergence ultimately resolve?

Financial Conditions Have Already Tightened Sharply Beneath the Surface

On the surface, the stock index appears calm. But Wilson points out that the real tightening has long been unfolding below the surface.

Morgan Stanley's composite financial conditions indicator—combining 52-week Z-scores of interest rates, the dollar, and energy prices—has climbed to roughly 1.4 standard deviations, second only to the levels seen during the aggressive 2022 rate-hike cycle. This tightening does not stem from a single variable but from a resonance of multiple factors: the Fed raised the federal funds rate by 25 basis points last month to 3.75%–4.00%, with Fed Chair Warsh citing strong labor data, sticky inflation, and geopolitical pressure on commodities as justification; at the same time, the 10-year Treasury yield has risen by roughly 130 basis points cumulatively since February, of which about 120 basis points came from rising real yields.

Wilson emphasizes that the composition of the yield drivers is crucial. Historically, when yields rise on the back of breakeven inflation expectations, equities can usually absorb it; but when the rise is driven by real yields, it tends to exert more direct pressure on valuations—which is precisely why the stock-bond correlation has turned significantly negative right now. He also notes that against a backdrop of nominal GDP growth near 6%, a 10-year yield holding above 5% is not anomalous—the ultra-low rates of the 2010s were the historical aberration, and the bond market is merely returning to equilibrium.

Ordinary Stocks Have Already Absorbed the Real Shock

The cost of rising yields is being digested disproportionately by ordinary stocks.

Wilson's breadth indicator shows that the share of S&P 500 constituents above their 200-day moving average fell to 43% in late September, approaching the 44% low of late March, and although it has since edged back up to 50%, the overall pressure has not dissipated. The S&P 500 forward P/E ratio is also retesting the roughly 19x level near its March low. Even more noteworthy, the S&P 500 equity risk premium (forward earnings yield minus the 10-year yield) has fallen below zero—a level that has barely been seen since 2002.

The "stability" at the index level masks structural damage. Financials are another warning signal—the sector fell 7.7% over 30 days, and its performance relative to the S&P 500 has fallen back to its lowest level since 2019. Wilson regards the financials' trajectory as "one of the most important reference indicators for near-term equity direction," and ahead of the big-bank earnings season, whether the sector can stabilize will be a key observation window for judging the market's direction.

Is This a Valuation Problem or a Growth Problem?

Wilson believes the current shock remains at the valuation level and has not yet evolved into a growth threat—but this judgment itself is contested.

The data supporting his relatively optimistic stance includes: nominal GDP growth just recorded 8.5%, and median earnings growth for S&P 500 constituents is running in the low-teens range; the gap between the federal funds rate and core CPI is about 1.4%, "far below the peak levels seen before past recessions"; and the 10-year/2-year Treasury yield spread maintains a positive slope of about +45 basis points, indicating the market has not yet priced in a recession. Wilson concludes from this that when the above conditions are met, "growth deterioration has rarely occurred within 12 to 18 months historically."

However, he himself concedes that an equity risk premium falling to zero is likewise a historically rare state. Goldman's Pasquariello flags risk from another dimension: the wave of lock-up expirations in 2027 could push net US equity supply to its highest level since the 2000 dot-com bubble, at which point the market's supply-demand balance could come under pressure.

Two Convergence Paths—Which Is More Likely?

The divergence will eventually converge—the question is whether ordinary stocks catch up to the index, or the index converges downward toward ordinary stocks.

Wilson offers two trigger conditions to watch: first, stabilization in financials, and second, a decline in the MOVE index, which measures Treasury volatility. He notes that both have already shown some signs of stabilizing, but more follow-through is needed. According to Bloomberg, Goldman's Rich Privorotsky recently observed that implied volatility on the long end of the bond curve has fallen about 30% from recent highs, providing the market some breathing room.

The coming weeks will be a critical test. September CPI data, Warsh's remarks at the IMF, and the October 28 FOMC meeting will arrive in succession. Consensus expectations show that, driven by a 9.6% month-over-month surge in gasoline prices, September CPI could jump 0.6% month-over-month, with the year-over-year rate rising to 3.6%. Wilson believes that if the core CPI reading is moderate and Warsh acknowledges that tightening financial conditions have already partially substituted for rate hikes, the current pressure could ease at the margin.

But Wilson's bull case (corresponding to an S&P 500 target of 8,300 points) and Pasquariello's operational logic of "shorting fixed income and going long the Nasdaq 100" are essentially bets on two diametrically opposed outcomes. With the equity risk premium at zero, breadth indicators approaching dot-com-bubble levels, and a potential supply shock looming—under the combined weight of all three, the market's preparation for the tail risk of "the index converging downward" may be far from sufficient.

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