The U.S. stock market is navigating a profound divergence that has caught many investors off guard: while the S&P 500 hovers just below record highs, the median stock within the index is enduring a 16% drawdown. Despite this unusual disconnect, a growing consensus on Wall Street suggests the market is poised to resolve in favor of the bulls, driven by expectations that recent tentative strength among the majority of stocks will support investors who have not fully committed to mega-cap leaders.
This split has become the dominant topic of discussion as the current bull market approaches its fourth anniversary. Historically, sectors such as semiconductors, which are down 17% from their peaks, and major banks, off 13%, would signal significant risks to the leadership and sustainability of a rising market. However, current sentiment remains unusually optimistic.
Lee Coppersmith, co-head of equity-derivatives sales at Goldman Sachs, acknowledged that breadth has deteriorated to its weakest point since the DotCom bubble era. Nevertheless, he argues that the headline index masks the difficulty of trading underneath, asserting that narrowness is not necessarily a warning sign. Coppersmith expressed confidence that the S&P 500 will climb higher over the next one to three months.
Morgan Stanley equity strategist Mike Wilson highlighted that while rising Treasury yields have altered the outlook for broadening performance, the risk in most stocks has been largely priced out ahead of earnings season. Wilson noted that although higher rates are impacting average stocks, their valuation adjustments have already occurred, leaving room for a catch-up if yields stabilize.
Deutsche Bank strategists recently downgraded the tech sector, citing crowded positioning and a high bar for earnings to satisfy Wall Street. Yet, they predicted that a reset in tech could create an opening for other sectors and small caps to rise. Data from Trivariate Research indicates that only 34% of large-cap stocks have outperformed the S&P 500 over the past year, a figure near the lower end of historical ranges.
Despite the challenges, professional investors have benefited from a mechanical dispersion trade that has supported the index while suppressing volatility. For instance, on Monday, declines in Nvidia and Micron were almost entirely offset by gains in Apple and Meta, allowing the S&P 500 to finish nearly flat.
However, John Kolovos of Macro Risk Advisors warned that the current disconnect is fragile. He stated that if index strength persists without meaningful improvement in market breadth, the path forward could become increasingly difficult, potentially dragging down the entire market, including technology. Credit spreads have widened, the equal-weighted S&P 500 is testing relative lows, and the Russell 2000 is sitting at its 200-day moving average. The XMAG ETF, which tracks stocks excluding the Magnificent 7, signals a potential technical breakdown if it dips slightly further.
Looking ahead, the market’s trajectory will likely depend on how equities respond to another quarter of strong earnings growth from the AI sector. While AI hardware companies have seen strong profit expectations, their valuations have not held up, suggesting investor concern about the durability of these profit moats. Meanwhile, earnings growth for median companies outside of tech, the Mag 7, and energy is projected to slow to 7% in the third quarter from 12% in the second, according to Bank of America.
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