“Weakest We’ve Ever Witnessed”: Morgan Stanley Warns Crashing Breadth Will Result In “Material Correction”

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Two weeks ago, when stocks suffered a modest airpocket, we pointed to something ominous: market breadth has been collapsing similar to what we observed last summer when a handful of market “generals” did all the heavy lifting. And as the following Bloomberg chart showed, market breadth had recently gone from bad to abysmal, with the number of S&P stocks above their 50DMA at just about 50%, a very tiny increase from the 47% on June 29 when the S&P hit its first of many consecutive all time highs.

And while stocks have since managed to recover from the wobble earlier this week when the S&P dipped 3.5% from all time highs in two sessions, banks are starting to pay close attention to the composition of gains and issuing warnings of their own, and none more so than Morgan Stanley.

In a recent note from the company’s increasingly “doom and gloomish” chief equity strategist Michael Wilson, who recently re-emerged as Wall Street’s biggest bear, and who reminded clients that his core view for 2021 was that earnings would surprise to the upside “but that valuations would come down to offset some, if not all, of the positive earnings revisions.”

Wilson points out that during the mid-cycle transition, forward P/Es typically fall by 20% while so far, P/Es have only fallen by 5% while forward earnings are up close to 20%,hence an S&P 500 that is currently up approximately 15%. As he warns, “if our narrative and framework are correct, P/Es should start to fall sharply over the next few months, bringing the index closer to our year-end target of 3900.

But what about market breadth?

Well, as Wilson adds, in addition to all of the other market signals that support his midcycle transition narrative, “the overall market breadth has deteriorated significantly.” He notes that this is also consistent with a mid-cycle transition “and usually precedes a material index level correction that marks the end of it.”

How bad is the breadth? According to the Morgan Stanley strategist, over the last month, “it’s the weakest we have ever witnessed, with the S&P 500 making new all-time highs.” More specifically, there are more stocks making new 52-week lows than highs when looking at the broad universe of stocks in the US market.

Further, the % of stocks trading above the 50 Day moving average is below 50% for the S&P 500 and it’s much worse for lower quality indices.

At the same time, the equal-weighted S&P 500 relative to the market-cap-weighted S&P 500 has rolled over hard.

Here Wilson reminds clients that a year ago, he was recommending equal-weighted S&P 500 over market-cap-weighted as a way to play the early part of the recovery “but now that part of the cycle is over and this is just another confirmation and falling fast.”

Finally, and most ominously, the strategist writes that while the ratio of cyclical to defensive stocks rolled over at about the same time, we called for the mid-cycle transition back in March, it completely broke down last week, signaling we may now be entering that more vulnerable time for the index – i.e.a much more defensive rotation.”

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