Recently, an unusual phenomenon has occurred in the US stock market: despite the indexes remaining near historical highs, market breadth is at historically the "worst level." Some believe that breadth as a price signal may not be as important as in the past. However, Morgan Stanley warns that ignoring breadth is often a "bad idea," and this anomaly may signal market risk.

Recently, Michael Wilson, Chief US Stocks Strategist at Morgan Stanley, released a report stating that the past week indicates that breadth has anticipated "the Federal Reserve may not provide as much easing as the market expects."

Investors focus on price momentum, ignoring warnings about market breadth.

In fact, the deterioration of market breadth that began in early December coincided almost exactly with the rise in the yield of 10-year US Treasury bonds. Morgan Stanley pointed out that when yields breach the key threshold of 4.5%, interest rates begin to exert resistance on stocks, and when this occurs, the correlation with stock PE becomes negative.

As investors increasingly favor price momentum as a key factor in their investment strategy, and due to the lack of mean reversion in recent years, the importance placed on rebalancing by investors has diminished, leading to extreme concentration in many stock markets, including the US stock market.

Morgan Stanley believes that this focus on price momentum and the resulting concentration may explain the disconnection between breadth and price, as well as why many investors choose to ignore warnings about market breadth until dramatic changes occur in the market.

On the other hand, the appeal of quality and momentum strategies in Large Cap stocks, combined with the rise of low-cost passive investment products, has led to a continuous widening of the price spread, that is, the difference between the percentage of the S&P 500 Index relative to its 200-day moving average and the proportion of stocks within the S&P 500 that are above their respective 200-day moving averages.

As excess liquidity declines, anomalies may disappear simultaneously.

Notably, over the past 25 years, these ratios have typically moved in sync, with only two instances where the S&P 500 Index was 'high' relative to this breadth indicator, which occurred in 1999 and from April 2023 to the present.

In addition to the above-mentioned drivers, a common feature of these two periods is that the Federal Reserve and/or the Treasury provided ample liquidity:

In 1999, the Federal Reserve maintained an accommodative policy to guard against the Y2K transition risk at the end of the year, and after the new year arrived, liquidity tightened, leading to a rapid narrowing of these ratio spreads.

The anomaly since April 2023 began with the $2.5 trillion peak in reverse repurchase agreements (RRP) and the injection of $500 billion in reserves to address the regional bank crisis.

However, the current question is whether a decrease of the RRP to zero and the Federal Reserve lowering interest rates less than expected would lead to a tightening of liquidity early next year, thereby reducing this anomalous gap. On the other hand, if the Federal Reserve lowers rates more than expected or ends Algo tightening, will liquidity remain strong?

Morgan Stanley believes that it is difficult to know, but when liquidity abundance fades, the abnormal divergence between breadth and price emphasized by many may normalize. In addition, for some high-quality Indices, breadth may not be as important as it was in the past.

According to last week's stock price adjustments, expensive growth Stocks and low-quality cyclical Stocks seem to be most affected by long-term high interest rates and declining liquidity, as the RRP mechanism is gradually diminishing.