The stock market's record-breaking run is masking a dangerous trend brewing under the surface, Morgan Stanley says

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Stock market breadth isn't as strong as it seems on the surface, Morgan Stanley said.

• The stock market's rally to new highs is not an entirely bullish story, according to Morgan Stanley's equity strategists.
• The rally has been narrow as it has excluded some key tech stocks that had propelled the market higher.
• Other gauges of so-called market breadth are of concern to them.

As the stock market soldiers on to new highs, some less bullish trends are brewing under the surface, according to equity analysts at Morgan Stanley.

They've have warned all year long that stocks are in a rolling, drawn-out bear market.

While their thesis appears to fly in the face of the market's record highs, they're pointing to a group of indicators that suggests a rough patch ahead.

It's market breadth, used by technical analysts to gauge the direction beyond what a plain chart of the S&P 500 shows.

One key measure of breadth, which tracks the share of New York Stock Exchange-listed companies advancing versus those declining, rose to a new high in mid-August. But for Michael Wilson, the chief equity strategist at Morgan Stanley, there are "too many other measures of breadth" that are worse.

"Specifically the % of stocks making new highs, the % of stocks above their 200-day moving average, the performance of equal weighted indices versus their market cap weighted sidekicks at both the broad index level and sector level are all showing signs of deteriorating breadth."

For more proof that the stock market's advance to new highs has been narrower than is obvious, Wilson pointed to tech stocks.

The sector led the market's rise last year and early in 2018, but investors have knocked it off that pedestal in the place of healthcare stocks. Over the past two months, healthcare has gained 8% and contributed to more than a quarter of the S&P 500's total return, according to Goldman Sachs.

Notably, big tech companies loved for their growth prospects fell out of favor amid concerns about how they handled their users' personal data.

But one bullish takeaway from tech's drop has been that the broader market has continued to rally without their support.

However, Wilson noted that some of these stocks, including members of the so-called FAANGS like Alphabet and Apple, have the greatest pull in the market cap-weighted S&P 500. For him, this means the risk to the S&P 500 is ultimately to the downside if tech stocks continue to falter.

"In our view, the narrowness of the S&P 500 has become extreme in this latest move to new highs and much more narrow than in January's prior high as already noted in the measures cited above," he said.

Wilson observed that the S&P 500 excluding Apple, Amazon, and Microsoft has not yet made it to new highs even though the S&P 500 has.

"We continue to think the market is speaking loudly with its defensive rotation, weak breadth and underperformance in former tech leaders," Wilson said.

"The message? The market seems to be (rightly in our view) worried about growth slowing later this year and next ... the bottom line is that we think the rolling bear market that began in January has unfinished business with US growth and small cap stocks the most vulnerable."

Morgan Stanley