Morgan Stanley: Half of Russell 3000 constituents have entered a bear market; U.S. Treasury volatility will determine the future direction of U.S. stocks.

October 5 — Morgan Stanley Chief Equity Strategist Mike Wilson said in his latest report that U.S. equity indices remain near record highs, but the market's internals have clearly diverged. 51% of Russell 3000 constituents are down more than 20% from their June highs, the median S&P 500 constituent is 16% below its 52-week high, and market breadth has fallen to its lowest level since the dot-com bubble burst. At the same time, there is a divergence gap of about 12% between index prices and market breadth.

Wilson believes the key to determining how this gap closes is U.S. Treasury volatility. The 10-year Treasury yield has now risen to 5.25%, the MOVE Index has broken above 100, while the VIX remains below 15. If bond volatility remains elevated, the S&P 500 could pull back about 6% over the next month to around 7,300 points, followed by a rebound toward year-end; if bond volatility falls first, catch-up gains in individual stocks could push market breadth toward the index.

The report notes that the deterioration in market breadth mainly began after the late-August Jackson Hole meeting, because investors began pricing in a more hawkish Federal Reserve policy path, rather than because of rising oil prices. Wilson believes the current weakness is mainly reflected in valuation compression, not a stall in corporate earnings. He recommends sticking at this stage with large-cap quality stocks whose earnings revisions continue to improve, especially asset-light companies with high free cash flow yields, low accruals, and high sales per employee; if the index completes a pullback, opportunities to add exposure to higher-risk stocks may emerge in the coming month.