MORGAN STANLEY: An overlooked signal could determine the future of the stock market - and early indications suggest a tough road ahead
- With the removal of a key technical indicator, the ongoing equity bull market runs the risk of losing steam on weak internals.
- Morgan Stanley explains why narrow leadership and overt divergence between market sectors worsens the overall equity outlook for 2019.
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Morgan Stanley thinks investors are missing out on a crucial underlying market signal - one that could very well determine the longevity of the ongoing bull market.
The firm is referring to breadth, which measures how many stocks in an index are rising versus the number that are falling. Strong breadth means a large number of companies are doing the heavy lifting, while a weak reading implies that gains are concentrated in the hands of just a few.
In short, the more individual stocks participating in a move, the stronger the trend at hand, and vice versa.
In an environment where myriad factors are pushing and pulling equities at any given time - the trade war, Federal Reserve monetary policy, and earnings growth chief among them - breadth is a good reality check for the actual health of the market. To that end, Morgan Stanley has a stark warning.
The firm has been watching breadth for weeks, and it says the metric has flipped away the bullish territory it occupied a few months ago. In fact, Morgan Stanley noticed some key warning signs, such as the underperformance of cyclicals and the outperformance of defensive shares.
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"We sensed that people were too focused on the major averages and were not heeding the warnings from these important market internals, not to mention the very strong message from the bond market and yield curve," Mike Wilson, the firm's chief US equity strategist, wrote in a client note.
He continued: "In the past few weeks, it looks like the major averages are now succumbing to these weaker internal signals."
This is significant because the investment landscape becomes vastly more nebulous when breadth is overlooked.
Think of it this way: Forecasters searching for a leg up on the competition may be led astray when a few large-cap securities move up (or down) in sequence, drowning out the moves of more populous, smaller-cap stocks. Without evaluating breadth line, market moves become increasingly less clear.
With that being said, if utilized efficiently, analyzing the total number of individual stocks participating in a rally or sell-off provides investors with a much more transparent, definable view of the underlying health and sustainability of the trend at hand.
Remember, a handful of stocks can represent large moves in indices, but may not be fully representative of the markets' overall well-being. This is why surface level analysis is so misleading, and needs to be vetted and confirmed by internals.
Which is why it's such a red flag that Morgan Stanley thinks investors have missed the latest signal.
What the removal of technical support has also done is push corporate fundamentals back into the forefront. And to Morgan Stanley, that's yet another negative sign. In the end, the big takeaway is that further turmoil may lurk ahead if these metrics continue to deteriorate.
"The difference between today's break and the one on March 8 is that the internals and the fundamentals are weaker today," Wilson said. "The technicals may hold even more importance than usual now."