Written by: Zhang Yaqi
U.S. stocks are staging a rare internal rupture—the index stands firm, but beneath the index there is carnage.
Morgan Stanley Chief U.S. Equity Strategist Mike Wilson warned in his latest report that **tightening financial conditions are quietly doing part of the Federal Reserve's work, except that this shock is being absorbed disproportionately by ordinary stocks rather than the handful of AI-centric giants.** With the 10-year Treasury yield breaking above 5.3%, the dollar rising to a new high for this cycle, and oil prices staying elevated, under the combined weight of these three pressures, 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—the last time being in 2022, when the Fed raised rates by 75 basis points at every meeting. Meanwhile, Goldman Sachs has revised its forecast to one more rate hike at the October FOMC.
The market's key fissure is now clearly visible: the S&P 500 equal-weight index has lagged the market-cap-weighted index by 6% over the past six months; in September, when the 10-year yield broke above 5%, the equal-weight index fell 5% for the month while the cap-weighted index was roughly flat. Although Goldman's Tony Pasquariello is partly reserved about the "breadth collapse" thesis, he acknowledges that the median S&P 500 constituent has fallen 15% from its 52-week high, the worst reading since the bursting of the internet bubble. The disagreement between the two major institutions precisely sketches the market's most central suspense: how will this divergence end?
Financial conditions have already tightened substantially beneath the surface
On the surface, stock market indices appear calm. But Wilson points out that the real tightening has long been unfolding below the waterline.
Morgan Stanley's composite financial conditions gauge—a 52-week Z-score combining interest rates, the dollar, and energy prices—has climbed to about 1.4 standard deviations, second only to the level of the 2022 aggressive hiking cycle. This tightening does not come from a single variable but from a confluence of factors: last month the Fed raised the federal funds rate by 25 basis points to 3.75%-4.00%, with Fed Chair Warsh citing strong labor data, sticky inflation, and geopolitical upward pressure on commodities; at the same time, the 10-year Treasury yield has risen by about 130 basis points since February, of which roughly 120 basis points came from the rise in real yields.
Wilson stresses that the composition of yield drivers is crucial. **Historically, when yield increases are driven by breakeven inflation expectations, the stock market can usually digest them; when increases are dominated by real yields, they tend to put more direct pressure on valuations—which is exactly why the stock-bond correlation has turned significantly negative.** He also notes that, with nominal GDP growth near 6%, a 10-year yield above 5% is not abnormal—the ultra-low rates of the 2010s were the historical anomaly, and the bond market is merely returning to equilibrium.
Ordinary stocks are already bearing the real shock
The cost of rising yields is being absorbed disproportionately by ordinary stocks.
Wilson's breadth gauge shows that the share of S&P 500 constituents trading above their 200-day moving average fell to 43% at the end of September, close to the late-March low of 44%; although it has since edged back up to 50%, overall pressure has not dissipated. The S&P 500 forward P/E has also retested around 19x, near the March low. More noteworthy is that the S&P 500 equity risk premium (forward earnings yield minus the 10-year yield) has fallen below zero, a level almost unseen since 2002.
"Stability" at the index level masks structural damage. Financials are another warning signal—the sector has fallen 7.7% in 30 days, and its relative performance versus the S&P 500 has dropped to the lowest level since 2019. Wilson regards the trajectory of financials as "one of the most important reference indicators for the near-term direction of the stock market"; before the large banks' earnings season kicks off, whether the sector can stabilize will be a key window for judging the market's direction.
Is this a valuation problem or a growth problem?
Wilson believes the current shock is still at the valuation level and has not yet evolved into a growth threat—but this judgment itself is contentious.
The data supporting his relatively optimistic stance include: nominal GDP growth has just come in at 8.5%, and median S&P 500 constituent earnings growth is running in the low-to-mid teens; the gap between the federal funds rate and core CPI is about 1.4%, "far below peak levels before past recessions"; the spread between 10-year and 2-year Treasury yields maintains a positive slope of about +45 basis points, indicating the market has not yet priced in a recession. Wilson concludes on this basis that, with the above conditions met, "historically, growth deterioration within 12 to 18 months has been rare."
Yet he himself admits that an equity risk premium falling to zero is also a historically rare state. Goldman's Pasquariello flags risk from another dimension: the wave of lock-up expirations in 2027 may push net U.S. equity supply to the highest level since the 2000 internet bubble, and the market's supply-demand balance may come under pressure at that point.
Two convergence paths—which is more likely?
Divergence will eventually converge—will ordinary stocks catch up to the index, or will the index converge downward toward ordinary stocks?
Wilson offers two trigger conditions to watch: **first, financials stabilizing; second, the MOVE index, which measures Treasury volatility, falling back.** He notes that both have shown some signs of stabilization, but more follow-through is needed. According to Bloomberg, Goldman's Rich Privorotsky recently observed that implied volatility on long-end bonds has fallen about 30% from its recent high, giving the market some breathing room.
The coming weeks will be a key testing period. September CPI data, Warsh's remarks at the IMF, and the October 28 FOMC meeting will follow in succession. Consensus expectations show that, affected by a 9.6% month-on-month surge in gasoline prices, September CPI may jump 0.6% month-on-month and rise to 3.6% year-on-year. Wilson believes that if core CPI is moderate and Warsh acknowledges that tighter financial conditions have already substituted for part of the rate hikes, current pressure may ease at the margin.
But Wilson's bullish base case (corresponding to an S&P 500 target of 8,300) and Pasquariello's trade logic of "short fixed income, long Nasdaq 100" are essentially bets on two diametrically opposed outcomes. With the equity risk premium at zero, breadth indicators approaching internet-bubble levels, and a potential supply shock looming—under the weight of all three, the market's preparation for the tail risk of "the index converging downward" may be far from sufficient.