Morgan Stanley expects the gap between the S&P 500’s performance and weaker market breadth to narrow over the next month, with the direction of bond market volatility likely to influence how the adjustment develops.
The bank said it expects the index and broader market participation to move towards each other if bond volatility remains elevated.
“We lean toward a meeting in the middle if bond vol doesn’t calm down,” strategist Michael Wilson wrote in a note earlier this week.
Morgan Stanley continues to view the equity market as being in a mid-cycle phase, with earnings growth offsetting lower valuations and higher-quality stocks taking a larger role in market performance.
“The equity market is not complacent around the risks,” Wilson wrote.
The bank noted that more than half of the stocks in the Russell 3000 have declined at least 20% since June. Meanwhile, the S&P 500’s price-to-earnings ratio has returned to around 19 times, close to its March low, while earnings growth for the median stock remains in the mid-teens.
“Market breadth improved through most of the summer even as energy prices and yields rose, while the momentum factor experienced one of its worst drawdowns in history,” Wilson added. “The recent narrowing in breadth occurred after Jackson Hole as the market priced a more hawkish Fed path.”
Bond Volatility Remains a Key Factor
Morgan Stanley said that if bond volatility remains elevated, it expects broader market participation and index prices to move towards each other over the coming month, followed by what the bank forecasts will be a stronger finish to the year.
If bond volatility declines sooner, Morgan Stanley expects market breadth to move closer to the performance of the index, with both potentially moving higher.
Wilson continues to favour large-cap quality stocks, particularly asset-light companies with rising earnings estimates. The strategist said he would increase exposure to higher-risk stocks during the next month if the index declines.
Morgan Stanley also highlighted the financial performance of companies making extensive use of artificial intelligence. The bank said businesses with greater AI adoption are recording higher margins and earnings.
According to Morgan Stanley, consensus estimates assume that some of those financial benefits moderate in later years. The bank said this could leave scope for earnings estimates to increase further if the benefits persist for longer than currently forecast.