The most dangerous divergence in U.S. stocks: ordinary stocks have already plummeted, how much longer can AI giants hold on?

The US stock market is undergoing a rare internal split—indexes seem stable, but beneath the surface, there is chaos.

Mike Wilson, Chief Equity Strategist at Morgan Stanley, warned in his latest report that tightened financial conditions are quietly doing part of the Federal Reserve’s job, but this shock is being mainly absorbed by regular stocks rather than the handful of AI-focused giants. The 10-year US Treasury yield has broken through 5.3%, the dollar has reached a new cycle high, and oil prices remain elevated. Under this triple pressure, Morgan Stanley's Composite Financial Conditions Index has jumped to about 1.4 standard deviations—a level breached only a few times in the past 35 years, with the previous instance during the 2022 Fed phase when rates were hiked by 75 basis points per meeting. Meanwhile, Goldman Sachs has revised its forecast, now expecting another rate hike at the October FOMC meeting.

The key fault lines in the market are now clear: Over the past six months, the S&P 500 equal-weight index has underperformed the market-cap-weighted index by 6%. In September, when the 10-year yield broke 5%, the equal-weight index fell 5% in a single month, while the market-cap-weighted index was nearly flat. While Tony Pasquariello of Goldman Sachs is somewhat skeptical of the "breadth collapse" verdict, he admits that the median S&P 500 component is down 15% from its 52-week high—the worst reading since the dot-com bubble burst. The disagreement between the two major institutions sketches out the core suspense in today’s market: How will this divergence end?

On the surface, stock market indexes appear calm. But Wilson points out that true tightening has long been unfolding below the surface.

Morgan Stanley’s Composite Financial Conditions Indicator—which combines the 52-week Z-scores of interest rates, the dollar, and energy prices—has risen to about 1.4 standard deviations, second only to levels seen in the aggressive 2022 rate hike cycle. This tightening is not driven by a single variable, but by a multi-factor resonance: Last month, the Federal Reserve raised the federal funds rate by 25 basis points to 3.75%-4.00%; Fed Chair Waller cited strong labor data, sticky inflation, and geopolitics pushing up commodities. Meanwhile, the 10-year US Treasury yield has risen about 130 basis points since February, with roughly 120 basis points coming from higher real yields.

Wilson emphasizes that the composition of yield drivers is critical. Historically, when yield increases are driven by breakeven inflation expectations, the stock market can usually absorb them; but when increases are led by real yields, it tends to put more direct pressure on valuations—that’s why stock-bond correlations are now markedly negative. He also notes that, with nominal GDP growth near 6%, a 10-year yield above 5% is not unusual—the ultralow interest rates of the 2010s were the real anomaly, and the bond market is simply returning to equilibrium.

The cost of higher yields is being disproportionately absorbed by regular stocks.

Wilson’s breadth indicator shows that, at the end of September, only 43% of S&P 500 constituents were trading above their 200-day moving average, close to the March low of 44%. That number has since rebounded to about 50%, but overall pressure remains. The S&P 500’s forward price-earnings ratio has also retested the March low, around 19 times. Even more notably, the S&P 500 equity risk premium (forward earnings yield minus the 10-year Treasury yield) has fallen below zero—something that’s been almost unheard of since 2002.

Index-level “stability” masks underlying structural damage. Financial stocks are another warning sign—the sector dropped 7.7% in 30 days, with relative performance versus the S&P 500 at its lowest since 2019. Wilson sees financials’ performance as “one of the most important near-term indicators for market direction.” Whether the sector can stabilize ahead of major bank earnings will be a key window for gauging market trends.

Wilson believes that the current shock is still at the valuation level and hasn’t turned into a growth threat—though this view itself is contentious.

Data underpinning his relatively optimistic stance include: Nominal GDP growth just posted at 8.5%, and the median S&P 500 constituent is seeing earnings growth in the teens; the gap between the federal funds rate and core CPI is about 1.4%, “well below peak levels before past recessions”; and the 10-year/2-year Treasury yield spread remains around +45 basis points, indicating the market hasn’t priced in a recession. Wilson thus concludes, “when these conditions are met, it’s historically rare to see growth deteriorate within 12 to 18 months.”

However, he also admits that single-digit equity risk premium is itself a historic anomaly. Goldman’s Pasquariello warns from another angle: The expiration of the 2027 lock-up period may push the net supply of US equities to its highest since the dot-com bubble, putting supply-demand dynamics under pressure.

Divergence will eventually converge: will regular stocks catch up with the indexes, or will the indexes fall to meet regular stocks?

Wilson offers two triggers to watch: First, stabilization in financial stocks; second, a decline in the MOVE index, which measures Treasury volatility. He notes that both have shown some stabilization, but more follow-through is needed. According to Bloomberg, Goldman’s Rich Privorotsky recently observed that implied volatility for long-term bonds has dropped about 30% from its recent peak, providing some breathing room for the market.

The coming weeks will be a crucial test. Key events in the pipeline: September CPI data, Waller’s comments at the IMF, and the October 28 FOMC meeting. The consensus forecast is that, driven by a 9.6% month-on-month surge in gasoline prices, September CPI could jump 0.6% month-over-month and rise to 3.6% year-over-year. Wilson believes that, if core CPI is moderate and Waller acknowledges that tighter financial conditions have partially substituted for rate hikes, current pressures could ease at the margin.

But Wilson’s bull-case scenario (with an S&P 500 target at 8,300 points) and Pasquariello’s “short fixed income, long Nasdaq 100” strategy essentially bet on two completely opposite outcomes. With equity risk premium near zero, breadth indicators at dot-com bubble levels, and potential supply shocks looming, the market may be far less prepared for the tail risk of “indexes converging lower” than it should be.