In recent weeks, the U.Sstock market has presented an intriguing anomaly: despite indices remaining near historical highs, market breadth is at what some analysts are calling its "worst level in history." While some market participants argue that market breadth—essentially the number of stocks participating in a rally—might not be as important a price signal as it once was, Morgan Stanley is sounding the alarmThe investment bank has warned that ignoring breadth could be a "bad idea" and that this divergence may signal underlying market risks.
Michael Wilson, Morgan Stanley’s chief U.Sequity strategist, highlighted in a recent report that the past week has revealed a concerning trend in market breadth, indicating that investors may be overly optimistic about the Federal Reserve’s ability to deliver the amount of monetary easing they expectAccording to Wilson, the deterioration in breadth that began in early December is nearly synchronized with the rise in U.S
Treasury yields, particularly the 10-year yield, which has recently surpassed the 4.5% thresholdAs yields rise, they start to pose a resistance to stock prices, and when this occurs, the relationship between stock prices and their earnings multiples—specifically the price-to-earnings (P/E) ratio—becomes negative.
The Growing Focus on Price Momentum
The shift in investor behavior is becoming increasingly apparent, with a growing number of traders focusing on price momentum rather than on broader market signals, such as market breadthThis shift comes after years of relatively weak mean reversion—where overvalued stocks eventually fall back toward their true value—which has made investors less attentive to the traditional practice of portfolio rebalancingThe consequence has been a highly concentrated stock market, particularly within the U.S., where large-cap stocks have dominated the rally.
Morgan Stanley suggests that this concentration of market interest in price momentum, and the subsequent lack of attention to breadth, is contributing to a disconnect between stock prices and the broader market’s underlying strength
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Investors are increasingly overlooking breadth signals, preferring instead to ride the wave of high-performing stocks until a market correction forces them to reassessThis trend, while profitable in the short term, raises the potential for larger market dislocations when the inevitable rebalancing occurs.
The Role of Large-Cap Stocks and Passive Investment
The appeal of large-cap stocks and momentum strategies has been magnified by the rise of low-cost passive investment products, such as exchange-traded funds (ETFs). These funds have driven a persistent divergence between the S&P 500 index’s performance and the percentage of stocks within the index that are trading above their 200-day moving averagesThis gap is seen as an indicator of how much of the rally is being driven by a small number of stocks, as opposed to broad-based participation across the market.
Morgan Stanley’s analysis points out that over the last 25 years, these ratios typically move in tandem
However, there have been two notable instances when the S&P 500 index has been significantly "high" relative to this breadth indicator: 1999 and from April 2023 to the presentBoth periods share the common characteristic of ample liquidity being provided by the Federal Reserve and/or the U.STreasury.
In 1999, the Fed maintained an accommodative policy to offset concerns about the Y2K transition, only to tighten liquidity sharply after the new yearThe result was a quick narrowing of the divergence between the index and market breadthSimilarly, the current anomaly, which began in April 2023, was fueled by a peak in reverse repurchase agreement (RRP) activity—where $2.5 trillion in short-term liquidity instruments reached their highest level—and a surge in reserves to address the regional banking crisisThis surge in liquidity has supported market prices, but there are growing concerns about how these forces will evolve in the coming months.
Liquidity Concerns and Market Anomalies
The key question now is whether the ongoing liquidity support will continue or whether it will diminish, triggering a normalization of the current market anomaly
The RRP mechanism, which has been a major driver of liquidity, is already shrinking, and if the Fed’s interest rate cuts fall short of expectations, the result could be tighter liquidity in early 2024, potentially causing the gap between price momentum and breadth to closeOn the other hand, if the Fed cuts rates more aggressively or ends its quantitative tightening program earlier than expected, liquidity could remain robust, supporting the continuation of current market dynamics.
Morgan Stanley has acknowledged that the current market environment is highly complex, with unique conditions where liquidity remains abundant, yet significant distortions in market breadth and price momentum are evidentMany have highlighted the divergence between breadth and price as an anomaly, but how this will resolve is uncertainOne possibility is that as liquidity begins to tighten, this divergence will eventually normalize
However, it’s important to note that in certain high-quality indices, breadth may no longer carry the same weight it once did.
The Impact of Growth and Cyclical Stocks
Recent price fluctuations have underscored the challenges faced by certain segments of the marketExpensive growth stocks, which have been highly overvalued, are under considerable pressure due to long-term high interest ratesTheir earnings expectations are being dramatically revised downward, making them vulnerable to a sharp correctionConversely, cyclical stocks, which are often of lower quality, are struggling to withstand the mounting risks posed by the tightening financial conditions.
The ongoing reduction in RRP activity, which has provided liquidity to the market, is exacerbating these risksAs liquidity tightens, both growth stocks and cyclical stocks are increasingly likely to face greater headwinds
This is particularly true for growth stocks that are trading at inflated valuations, as higher interest rates continue to erode their appealMeanwhile, cyclical stocks—often seen as more sensitive to economic conditions—are struggling to cope with the mounting risks of a potential slowdown.
The Potential for a Market Shift
The current market environment, with its high concentration in large-cap stocks and price momentum strategies, is unsustainable in the long runMorgan Stanley warns that ignoring breadth and the underlying risks of an overly concentrated market is dangerous, especially if liquidity begins to recedeWhile price momentum has been a powerful force driving stock prices higher, it may not be enough to sustain the current market structure if broader economic factors change, such as a tightening of liquidity or a reversal in investor sentiment.
Ultimately, the shift toward momentum-based investing, combined with the fading importance of market breadth, could lead to an even more concentrated market in the short term