Half of Stocks Have Entered a Bear Market! U.S. Stocks at a "Crossroads," Key Focus on U.S. Treasury Volatility

US stock indices are hovering near historic highs, but there has been a quiet split within the market.

Morgan Stanley's Chief Equity Strategist Mike Wilson issued a warning in his latest report: There is currently about a 12% divergence between market breadth and index price in US equities, and this gap must be closed somehow—either indices will correct downward to meet market breadth, or bond volatility will cool, leading to catch-up gains in individual stocks that push indices even higher. There are two paths with opposite directions, but ultimately, there is only one true arbiter: the US Treasury market.

Currently, 51% of Russell 3000 constituents have fallen more than 20% from their June highs, officially entering a bear market zone. The median S&P 500 stock is 16% below its 52-week high, and market breadth has fallen to its lowest level since the dot-com bubble burst. Meanwhile, the 10-year US Treasury yield has returned to 5.25%, the MOVE index, which measures US bond volatility, surpassed 100, while the "fear index," VIX, remains below 15. This rare divergence between equity and bond volatility has put the market on high alert.

Wilson concludes: If bond volatility does not calm, the S&P 500 could fall to around the 6800–7300 range within the next month before a potential year-end rebound; if bond volatility cools first, stock catch-up will drive both indices and breadth higher together.

Half the Stocks Are Deep in a Bear Market, "Inflated" Indices Mask Internal Collapse

On the surface, the S&P 500 index is still operating near all-time highs, but internal damage within the market is already severe.

In the latest "Weekly Warm-up" report, Wilson points out that 51% of Russell 3000 constituents are down more than 20% from their June highs, further deteriorating from "over 40%" two weeks ago. At the same time, the S&P 500 forward P/E ratio has fallen to about 19 times, equaling the lows during the peak of the Iran tensions in March of this year.

By sector, the damage is extremely unevenly distributed. In the semiconductor sector, 96% of stocks have fallen more than 20% from their June highs, with 69% down more than 40%; in autos, 71% of stocks fell more than 20%, and every auto stock has dropped at least 10%; for software, the figure is 75%. The banking sector is an exception, with only 4% of stocks seeing similar pullbacks.

Wilson characterizes these hit sectors as "typical early-cycle winners"—semiconductors and autos dramatically outperformed the market from the rolling recession low in April 2025 to June 2026. However, as Morgan Stanley signaled as early as June, the breadth of earnings revisions for these early-cycle winners has peaked, and the market is shifting from early- to mid-cycle, with quality factors set to start dominating. The Fed's hawkish turn is another classic signal of this cycle shift.

Goldman's data further confirms this judgment. According to Goldman Sachs TMT strategist Peter Callahan, the median S&P 500 stock is now 16% below its 52-week high, and market breadth has dropped to its lowest since the dot-com bubble burst. As early as May 1, Goldman warned that such a sudden decline in breadth "has historically preceded above-average drawdowns in the S&P 500 over the next 6–12 months." Five months later, this indicator continues to worsen.

The Fuse for the Breadth Collapse: Jackson Hole, Not Oil Prices

The deterioration in market breadth didn't happen overnight, and Wilson’s timeline analysis is particularly key.

Throughout the summer, the proportion of S&P 500 stocks above their 200-day moving average rose from 59% at the end of May to about 75%; even as oil prices and Treasury yields rose in tandem, market breadth was still improving. This trend, however, reversed sharply after late August’s Jackson Hole global central bank symposium, with the current ratio down to 49%.

Wilson highlights that the sudden narrowing of breadth wasn't caused by rising oil prices, but rather the market starting to digest a more hawkish Fed path after Jackson Hole.

"The same shift is clear in the rates markets. Faster nominal GDP growth and higher energy prices fueled the rise in yields in the first half of the year, but since late August, further increases in yields increasingly reflect the Fed's hawkish pivot—whereas this shift happening alongside robust economic growth isn't bad news for the overall stock market, it certainly affects which sectors lead the way."

Statistics from BTIG strategist Jonathan Krinsky provide further evidence from another angle: According to Bloomberg, there have been 57 trading days this year where price and breadth moved in opposite directions, matching the highest tally in the past 30 years—and there are still four and a half months left in the year.

Wilson quantifies the current gap between index and breadth as “about a 12% deficit in the S&P 500 that must be closed in some way”.

Fundamentals Haven't Collapsed, but Valuation Compression Is Underway

Yet, despite worsening breadth, Morgan Stanley and Goldman Sachs are unusually aligned on the fundamentals: Current market weakness isn't due to deteriorating fundamentals, but is a result of valuation compression.

Wilson points out that S&P 500 EPS revision breadth is at 25%, much higher than the lower-quality Russell 2000's 7%, and the median stock's EPS growth is in the low teens. "Since early June, the index has been treading water not due to stagnant earnings, but because valuations have absorbed the shock."

According to Goldman Sachs data cited by Bloomberg, S&P 500 Q2 EPS grew 51% year-on-year, and the forward P/E ratio has dropped from about 23 to around 19 times. In Goldman's 12-month target price of 8,700, there is almost no contribution from valuation expansion.

It’s noteworthy that Morgan Stanley’s EPS estimate for 2026 is $339, about 6% below the bottom-up consensus of $361—even this strategist who insists “earnings are carrying the load” forecasts a figure clearly below market consensus.

US Treasury Volatility: The Ultimate Variable Determining Market Direction

Wilson frames the current scenario as two outcomes, and the dividing line is entirely whether US Treasury volatility can cool down.

Scenario One: If bond volatility remains elevated, market breadth and index price will "meet in the middle" over the next month, implying about a 6% correction in the S&P 500, to around 7,300, followed by a strong year-end rebound.

Scenario Two: If bond volatility cools first, individual stock breadth will catch up to index price, pushing both higher together.

Wilson has long viewed 4.50% as the threshold at which the 10-year Treasury yield exerts substantive pressure on equity valuations. After the 10-year yield broke above this mark in May, S&P 500 forward P/E ratios have remained under pressure. As of last Friday, the 10-year yield returned to 5.25%, wiping out all post-payroll-release gains.

The MOVE index measuring Treasury volatility has now topped 100, while the VIX remains below 15. Wilson notes "the calmness of VIX is remarkable during the recent collapse in breadth and valuation", highlighting this anomaly with a red question mark. He believes whether and when bond and equity volatility synchronize will ultimately decide how the gap between breadth and index is closed.

"Waller Put Option": Exists, But No One Knows the Strike Price

Notably, Wilson discusses the variable of the new Fed Chair Waller and its impact on market pricing in his report.

Since Jackson Hole, the 2-year Treasury yield has risen nearly 60 basis points, with the market interpreting Waller’s signals as: it's not enough for inflation to fall—it needs to fall "quickly enough". September's rate hike further reinforced this reaction function.

However, Wilson believes the bond market might be overreacting. "In our view, bond markets may have recently adopted an excessively hawkish stance." He also notes that term premium remains well-behaved for now, which alleviates market concerns about fiscal sustainability or the Fed falling seriously behind the curve.

More critically, Wilson makes a unique interpretation of Fed Chair Waller's monetary stance:

"While markets may assume too many hikes over the next year, they may underestimate Waller’s willingness to use the balance sheet for deficit financing or to stabilize financial conditions at the first sign of trouble. Our view is that Waller will ultimately provide liquidity when necessary, but markets may want to test his resolve. The recent rise in yields and bond volatility is a step in that direction."

In other words, the "Waller put option" objectively exists, but the strike price is still unclear and the market appears to be actively seeking that level.

Wilson Recommends Sticking With Blue-chip Quality Stocks and Awaiting Entry Points

At this stage, Wilson recommends sticking with large-cap quality stocks, especially asset-light companies where earnings revisions are still improving, with a particular focus on quality and operational efficiency factors such as high free cash flow yield, low accruals, and high sales per employee.

If the index does pull back and completes the months-long adjustment "below the surface," Wilson believes that window will be the time to add higher-risk stocks—most likely within the next month.

On the AI theme, the sixth global AI landscape analysis of about 3,600 stocks by Morgan Stanley analyst Michelle Weaver indicates the market is rotating from "AI enablers" to "AI adopters." The consensus is that highly relevant AI adopters will see 4.6% EBIT margin expansion in 2025–2026, more than the S&P 500 overall. However, this advantage nearly disappears in longer-term forecasts, suggesting analysts have already priced in the early AI dividend but have yet to fully price in its sustainability.

In terms of valuation, highly relevant AI adopters’ next-twelve-month EPS is up about 70% in the past two years (enablers are up more than double), but the median adopter currently trades at just 18x forward P/E, on par with the MSCI World Index and far below enablers’ 22x.

Additionally, companies for which AI is "core to the investment thesis" outperformed those for which it is merely "important" by 107%; while companies facing core AI threats underperformed those facing moderate shocks by about 161%. The market is increasingly precise in pricing the degree of AI impact.