U.S. stocks are approaching record levels while participation across the market is deteriorating sharply, leaving Treasury-market volatility as the main near-term risk for the S&P 500. Morgan Stanley estimates a roughly 12% disconnect between index prices and underlying market breadth, a gap that could close through a pullback in the benchmark or through a recovery in participation if bond-market conditions settle.
The firm’s near-term outlook hinges on volatility in U.S. government debt. The 10-year Treasury yield has climbed back to 5.25%, while the MOVE Index, which tracks expected volatility in the Treasury market, has risen above 100. The VIX, Wall Street’s main gauge of expected stock-market volatility, has remained below 15.
That split is unusual: bond traders are pricing substantial uncertainty around rates, inflation and government borrowing, while equity options imply relative calm. Morgan Stanley said sustained Treasury volatility could push the S&P 500 into a 6% pullback zone near 7,300, with a wider one-month downside range of 6,800 to 7,300. A decline in rate volatility, by contrast, could allow more stocks to participate in the rally and reduce the gap with the headline index.
Record index levels mask broad losses
The weakness beneath the index is visible across major stock universes. According to Morgan Stanley, 51% of Russell 3000 companies have fallen more than 20% from their June highs. The median S&P 500 constituent is 16% below its 52-week high.
Goldman Sachs data cited by Bloomberg placed that breadth reading at its weakest level since the dot-com era. Such measurements matter because capitalization-weighted indexes can remain resilient when a relatively small group of large companies offsets declines across hundreds of smaller members.
The retreat has been particularly severe in several growth-sensitive industries. Morgan Stanley found that 96% of semiconductor stocks were down more than 20% from their June highs, and 69% had fallen more than 40%. In software, 75% of companies were down at least 20%. Autos showed similar strain, with 71% of the group down more than 20% and every tracked auto stock at least 10% below its peak.
These are sectors where valuations and earnings expectations tend to be sensitive to financing costs. Higher yields raise the discount rate applied to long-dated profits, while expensive borrowing can pressure businesses that rely on debt or capital spending to finance expansion.
Banks have provided a notable exception. Morgan Stanley reported that only 4% of bank stocks were more than 20% below their peaks. That resilience contrasts with the retreat in several early-cycle sectors that had led the market rebound from the April 2025 recession low through June 2026. A steeper yield environment can support bank lending margins, although the benefit depends on credit conditions and deposit costs.
Jackson Hole marked a turn in participation
The broadening that had developed earlier in the year appears to have reversed after late August. The proportion of S&P 500 stocks trading above their 200-day moving average rose from 59% at the end of May to roughly 75% during the summer, according to Morgan Stanley. It then fell to 49% following the Federal Reserve’s Jackson Hole symposium.
A 200-day moving average is commonly used to judge whether a stock is maintaining a longer-term uptrend. With fewer than half of S&P 500 members above that level, the index’s performance has become increasingly dependent on its strongest components.
BTIG data cited by Bloomberg recorded 57 trading days this year when stock prices and market breadth moved in opposite directions. That equaled the highest annual count in 30 years, despite four and a half months remaining in the calendar year when the tally was made.
The pattern does not automatically signal an imminent market break. Divergences can persist when earnings growth remains concentrated in large companies or when a small cluster of highly valued stocks continues to attract buying. It does, though, leave the market more exposed if those leaders weaken or if Treasury yields rise further.
Earnings remain stronger than price action
The breadth decline has occurred even as aggregate earnings measures have improved. Goldman Sachs data cited by Bloomberg showed S&P 500 second-quarter earnings per share rising 51% from a year earlier. The forward price-to-earnings ratio for the index has also compressed to about 19 times from roughly 23 times.
That combination suggests that some of the market’s valuation pressure has been absorbed by profit growth rather than solely by falling share prices. Yet earnings forecasts remain a point of disagreement. Morgan Stanley’s 2026 S&P 500 EPS forecast stands at $339, about 6% below the $361 bottom-up consensus estimate.
The gap places attention on whether companies can meet the more optimistic forecasts embedded in analyst estimates, particularly if rates remain elevated. Treasury-market volatility can affect equities through several channels: it alters valuation models, raises hedging costs, complicates corporate financing and can weaken confidence in economically sensitive sectors.
AI rotation is widening performance gaps
Morgan Stanley also identified widening differences within AI-linked stocks rather than a single uniform trade. In a screen covering roughly 3,600 global companies, the firm found that AI “adopters” traded at a median 18 times forward earnings, compared with 22 times for “enablers,” the companies providing chips, infrastructure and related technology.
The highly correlated adopter group was projected to deliver 4.6% EBIT-margin expansion across 2025 and 2026. Over two years, next-12-month EPS estimates for those adopters rose about 70%, while estimates for enablers increased by more than 100%.
Performance gaps have been even larger across Morgan Stanley’s AI classifications. Companies where AI was considered central to the investment case outperformed businesses where it was merely important by 107%. Companies identified as facing an AI-driven core threat underperformed those with a more moderate exposure by about 161%.
Those spreads help explain why the major indexes can remain firm even as breadth weakens. The market is rewarding a narrower set of companies with perceived earnings durability, AI exposure or favorable rate sensitivity, while punishing sectors facing higher borrowing costs or softer profit expectations.
For the S&P 500, the immediate test is whether Treasury volatility subsides before deteriorating participation reaches the index’s largest holdings. A calmer rates market would give lagging sectors room to recover; continued instability would leave a record-level index relying on an increasingly limited base of support.
Concerned about weakening breadth and volatility gaps? Deepen your macro perspective with our latest insights in Today’s Wall Street Outlook.
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