Morgan Stanley traders' frontline interpretation of U.S. stocks: Quick money has already run away, retail investors have not yet surrendered, and foreign capital is the biggest question mark

Foreign investors' stance on U.S. stocks is wavering, and Morgan Stanley states that the market may face a deeper adjustment.

Morgan Stanley's Quantitative and Derivatives Strategy (QDS) team is examining the recent market turmoil and believes that after experiencing this wave of market chaos, now is a critical moment to think about the next steps. While "fast money" has already exited, retail investors have not fully surrendered, and the key lies in the actions of foreign investors moving forward.

Morgan Stanley further points out that if foreign capital begins to question the "American exceptionalism" and withdraws from the U.S. market, then the stock market will bear more downside risk, and a new round of bottom-seeking may occur in the coming months.

The Market is at a Fragile Turning Point: Key to Watch Foreign Capital

According to the latest analysis from Morgan Stanley's Quantitative and Derivatives Strategy (QDS) trading desk, "fast money" has sold off—hedge funds' net exposure fell to 37% on Friday (currently risen to 39%, the second percentile since 2010), and macro systemic leverage has dropped to the 14th percentile, having previously sold off $375 billion worth of stocks.

At the same time, retail investors have not capitulated, and QDS's long-term investment clients have not shown signs of panic selling.

From a capital flow perspective, Morgan Stanley believes that one of the biggest questions is how foreign investors will act—because a true bear market scenario could be a reversal of the actual capital inflow to the U.S. from abroad over the past 20 years.

The report also emphasizes that over the past 30 years, the share of U.S. stocks held by foreign investors has been steadily increasing, currently holding 18% of U.S. stocks. If this group begins to question "American exceptionalism"—and has already reduced its investment in U.S. stocks—then there may be more downside risk in the future.

Morgan Stanley adds that while the outflow of structural capital from the U.S. remains to be seen and is not the basic scenario of QDS, it could drive extreme left-tail risks.

From a tactical perspective, QDS expects stocks may be more likely to rise than fall next week, but as the fundamental impacts of tariff shocks become evident and slow-moving investors sell stocks, the market will likely retest lows or create new lows in the coming months.

QDS states that despite some signs of capitulation recently (hedge fund net exposure < 40%, VIX index intraday > 50), there has not yet been a complete high-correlation sell-off, and unless there is a reversal in tariff policy, the bottom may look like a comprehensive high-correlation decline (including the dollar, bonds, and U.S. stocks).

QDS further points out that when the correlation among U.S. stocks soars above 80% (only reaching 60% last Friday), almost all dollar assets will have nowhere to escape.

Morgan Stanley believes this could force the Federal Reserve to restart quantitative easing or cut interest rates. Before that, investors should adjust their hedges during rebounds, selling stocks that are more susceptible to economic slowdown and those that are more affected by capital outflows from the U.S

Four Key Issues Determine Market Direction

Looking ahead, QDS focuses on four major issues, referred to as the 4 "F"s:

Fundamentals: The impact of tariffs takes months to fully manifest; how is the market currently reacting? Historical data shows that a 20% drop in the S&P 500 index typically indicates a recession (9 out of 13 times), with earnings per share (EPS) declining by more than 10%.

Fed: Will the Federal Reserve respond to the economic slowdown, or will it lag behind the situation? Powell's remarks suggest they are "not in a hurry," so assuming an economic slowdown, they will respond slowly. Sell during S&P 500 index rebounds before the Fed changes policy or reverses tariff policies.

Foreign flows: Among all capital flow dynamics, real capital—especially real capital outside the U.S.—has the potential to exert the greatest downward pressure.

Financial Leverage: Much leverage has been removed from the system, but not all, and the market has shorted Gamma. Implied volatility is currently too high, but it is worth holding Gamma during any downturn. Remember, after a shock, the upside may be greater than the downside—this means going long on call options / shorting delta.

Risk Warning and Disclaimer

The market carries risks, and investments should be made cautiously. This article does not constitute personal investment advice and does not take into account individual users' specific investment objectives, financial situations, or needs. Users should consider whether any opinions, views, or conclusions in this article align with their specific circumstances. Investment based on this is at one's own risk