Stock Market Outlook: S&P 500 to Drop 8% Before Fresh Rally, Morgan Stanley Says

The stock market may be headed for its worst correction since the Iran war, Morgan Stanley says.

The Wall Street bank is warning of more downside ahead for stocks, with the market set to face a handful of “clearing events” that could pressure equity prices in the coming months, strategists wrote in a client note this week. While the bank sees the S&P 500 ending higher by the end of the year, it floated the possibility that the benchmark index drops as low as 7,100 as equities come under pressure in the near-term.

A drop to that level would implies an 8% decline in the benchmark, marking the worst sell-off since the Iran war led the market to plunge earlier this year.

The bank sees the index ending 2026 at 8,000, a 12% rally once stocks hit a trough.

Mike Wilson, Morgan Stanley’s chief US equity strategist, said the bank held the view that stocks were in the midst of a monthslong correction that began in June. Though the major indexes have hovered near all-time highs, market breadth has weakened considerably since then, a sign that more stocks in the S&P 500 are struggling, though the tech trade is propping up the market in the aggregate.

Around 84% of S&P 500 stocks are trading 10% below their all-time highs, meaning the majority of the index is already in a correction, according to a recent analysis from The Kobeissi Letter.

“Bottom line: We think the correction that began in June is now in its final stages, with much of the damage already done beneath the surface,” Wilson wrote.

The bank said it saw three clearing events that could pressure stocks over the near-term. Here are the obstacles it’s eyeing:

1. Concerns related to AI and the cost of capital

The AI trade has struggled recently, thanks to a handful of interlocking concerns held by investors:

• AI spending might slow down. Anthropic’s reported third-quarter revenue figures startled investors with a sharp slowdown compared to growth in the previous quarter. Since then, investors have grown concerned that AI capex is running too high, while also worrying about what a slowdown in spending could mean for the broader trade.
• AI financing costs are growing. Credit spreads on data center-related bonds have widened in recent months. The widening reflects multiple factors, like higher borrowing costs, investors perceiving a greater risk to holding AI-related debt, and a sharp increase in the supply of debt being issued recently. All these factors are raising funding costs, which hurts AI firms.
• More AI debt is growing distressed. The health of AI debt is also coming under question. CoreWeave saw its debt slip into distressed territory this month, triggering fears of credit contagion and a broader fallout in the private credit and AI sectors.

These concerns are likely to “come to a head” over the next three to four weeks, Morgan Stanley predicted. Strategists said the recent increase in the supply of debt has been a key headwind for markets, and markets needed time to absorb the new debt issuance.

“We should find support in mid-November, about 10-15% lower,” strategists said of the chips sector in particular. “We think that low will coincide with the funding concerns bottoming.”

2. The midterm elections

The stretch leading up to the midterm elections is known to be challenging for stocks. In all midterm years since 1974, the S&P 500 has seen a median return of 0% from August 1st through the election day in November, strategists at Goldman Sachs wrote in a note this summer.

Historically, though, stocks have made up for the weakness by seeing strong performance in the months following the election. On average, the S&P 500 has gained 8% in the three months following the midterms, and was up 15% over the next 6-month period, Morgan Stanley said, citing its analysis of stock data from 1950 to 2022.

“Markets also loathe uncertainty and so just having it behind us can provide a positive catalyst in and of itself no matter what the outcome,” strategists said of the upcoming elections. “The historical performance of equity markets post-midterms should provide investors with the extra confidence to step in should a quick downdraft arise.”

3. Tighter financial conditions

Finally, markets are grappling with tighter financial conditions, which have weighed on risk asset prices. Wilson pointed to factors such as the Fed restarting its rate-hiking cycle in September, declining growth in the Fed’s balance sheet, and the broader impact of higher energy prices, which have led yields to spike in the bond market.

Higher yields tighten financial conditions without the Fed needing to raise interest rates, Wilson noted.

“This is the market tightening for the Fed and when combined with the sharp rise in energy prices, this may be enough to slow growth and inflation back to target. However, it could also cause stress in the markets they cannot tolerate which leads to a pivot before the job is complete. That would be asset price bullish in the short term,” he added.

Markets are waiting on the Fed to announce its next interest rate decision on Wednesday afternoon. Investors are pricing in a 90% chance the central bank will opt to keep rates steady, though more rate hikes are seen as likely through year-end and early 2027, according to the CME FedWatch tool.