The stock market is at a critical juncture. Wall Street is convinced it will resolve in the bulls' favor

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This is a deeply divergent stock market that almost no one saw coming and few are enjoying, but most everyone seems to think is about to resolve in their favor.

The extraordinary split between the headline S&P 500 pinned just under a record high and the median stock in the index struggling in a 16% drawdown has been the lead topic of conversation on Wall Street. And entering this week, a consensus is coalescing around the idea that last week's tentative firming in the majority of stocks will bail out investors not fully committed to the mega-cap leaders.

There was a time when semiconductors wallowing 17% below their peak and big banks off 13% would be hazard warnings for the leadership profile and staying power of a bull market just crossing its fourth birthday.

But not here and not now.

Goldman Sachs co-head of equity-derivatives sales Lee Coppersmith puts it this way:  "By our preferred GS measure, breadth has now deteriorated to its weakest level since the DotCom Bubble. The headline index continues to mask just how difficult the tape has been underneath. The big question we're getting from clients now is whether the market narrowness is a warning sign for the broader market. I'm increasingly of the view that it isn't, and continue to favor SPX higher over the next 1-3 months."

Morgan Stanley equity strategist Mike Wilson, who has been extolling the market's prospect for broadening performance on the back of broadening earnings growth, notes that rising Treasury yields have rewritten that script. No worry, he argues, because the risk has been taken out of most stocks entering earnings season: "Higher rates are being felt most acutely in the average stock, but the de-rating there has also run well ahead of any deterioration in earnings. If yields stabilize and revisions hold, that leaves room for a catch-up."

Deutsche Bank strategists downgraded the tech sector Monday, noting crowded investor positioning, a high hurdle for earnings to please the Street and the group's extreme recent outperformance in carrying the S&P 500 in recent months.

Even here, the downbeat note on the undisputed engine of the bull market is brightened with a prediction that a tech reset will open a lane for the rest of the market to relax higher: "Given its concentration, periods of tech outperformance typically spark concerns around market breadth, and the last two months have been no different. In our view, rotation into other sectors and small caps should alleviate those concerns."

It's no mystery why professional investors might root for the pendulum to swing away from the dominant benchmark-weight stocks toward the majority of tickers because the S&P 500 has been brutally hard to outperform. Trivariate Research shows with this chart that only 34% of large-cap stocks have beaten the S&P 500 over the past 12 months, near the low end of the historical range for this metric.

Trivariate Research

It's worth noting that most of the periods when the S&P 500 was easier to outperform were when the market as a whole was under pressure.

Still, as much as I'd love to say that the popular calls for a mean-reversion trade back toward a broader, more democratic market represent a lazy consensus unlikely to play out, over the past year the market has executed such immaculate rotations impressively. The mechanical "dispersion trade" has been a tireless support for the S&P 500 and a suppressant of index-level volatility.

Monday was a perfect example, when the two biggest drags on the S&P 500 were Nvidia and Micron, but were offset almost to the penny by gains in Apple and Meta, helping the index itself to finish a whisper from unchanged.

I've always said there's nothing wrong with a narrowly led advance. In fact, bull markets usually have a dominant theme that takes the indexes as far as they are going to go without fully surrendering the lead for long.

This requires, though, that the majority of stocks are not outright declining and that the divergences aren't accompanied by signs of acute macro stress and tighter financial conditions.

We're probably nearing a critical juncture to avoid the latter adverse setup. Credit spreads have widened, but not quite critically.  The equal-weighted S&P 500 has barely bounced off a new relative low versus the market-cap-weighted version, not far from where it started a prior countertrend bounce in May. The Russell 2000 is sitting right at its 200-day moving average.

And the XMAG ETF, made up of the 493 stocks not in the Magnificent 7, would signal a potential technical breakdown with a few more percent of downside.

This indicator from John Kolovos of Macro Risk Advisors uses several data points to reflect both what investors are saying and what they are doing.

Kolovos on the latest reading: "Earnings season couldn't come at a more important time to repair the damage beneath the surface. If we get several more weeks of index strength without meaningful improvement in breadth, historical evidence suggests that the longer these disconnects persist, the harder the path forward becomes, which could take the entire market down, including tech." 

-I was lucky enough to catch a screening of "You Can See Everything," the forthcoming documentary about disgraced Theranos founder Elizabeth Holmes by filmmakers Nathan Fielder and Lance Oppenheim.

Aside from a jarringly immersive portrayal of an unrepentant Holmes and her family in the days before she reported for her prison sentence, the film is a vivid picture of the Silicon Valley startup mindset that rides the line between determination and delusion.

Without giving away key narrative turns, Holmes and her husband Billy Evans work tirelessly to reboot a version of Theranos with a kind of desperation.

This version of the tech entrepreneur as always "betting the company," "failing fast" and working to defy the odds is relevant to the big-picture AI boom. The Big Tech platforms in 2022 were all massively profitable but maturing, run by CEOs imbued with the cult of the founder. This, arguably, helped dictate the free-spending, capital-intensive, "work harder not smarter" approach to building AI that has overtaken our financial markets.

An ongoing subject of discussion for sure. Meantime, the Holmes movie opens this Friday.

-This is a remarkably thorough, very long X thread from a few days ago detailing ways in which the AI investment boom could hit snags.

-This edition of the "Money Stuff" podcast features Jeremy Maletz, head of prediction markets at Susquehanna International. An instructive discussion about how these evolving markets are approached by one of the sharpest trading firms in the financial industry.

If indeed Treasury yields have put in a near-term peak with the 10-year's recent crest above 5.3%, the market can enjoy some breathing room for sure.

I don't subscribe to any inherent predictive value of the "equity-risk premium," which subtracts the 10-year Treasury yield from the forward earnings yield of the S&P 500 to get a read on relative bond-stock attractiveness. Whether this is above or below zero has the most to do with the absolute level of yields and whether inflation or stagnant growth is the principal threat.

Still, if nothing else this suggests less of a relative valuation cushion for equities at the moment.

Morgan Stanley

Far more important to me will be how stocks respond to another quarter of probable blowout earnings growth from the AI complex.

The AI hardware food chain, including memory chips and related industrials, has not held its valuation despite strong profit expectations, a sign that investors might collectively have concerns about "over-earning" in the near term and the long-term durability of profit moats.

And, according to Bank of America, median-company earnings growth outside of tech, the Mag 7 and energy is slated to slow to 7% in the third quarter from 12% in the second.

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