Morgan Stanley: Is the market about to start a catch-up rally?

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Morgan Stanley

It's time for Morgan Stanley’s weekly preview report. You might recall that last week, Morgan Stanley strategist Wilson mentioned that although the main indices are hitting new highs, market breadth continues to deteriorate. The rally is mainly supported by high-quality large-cap companies. This week, he elaborates further, stating that this divergence in the market could present new opportunities for investors.

Wilson notes that although the main indices remain elevated, many stocks underneath the indices have already taken a hit. Since June, 54% of the Russell 3000 Index constituents have fallen more than 20% from their highs. At the same time, the S&P’s forward 12-month P/E ratio has dropped back to 19 times earnings, near the low point in March of this year.

Meanwhile, corporate earnings have not weakened. The median individual stock EPS growth rate is still in the double digits, and the earnings revision breadth for the S&P is also near the cyclical high. To explain, ‘earnings revision breadth’ refers to the percentage of companies with upward earnings revisions by analysts minus those with downward revisions. In the S&P, this figure is 25%; for the lower-quality Russell 2000, it's only 7%, indicating that earnings improvements are mostly concentrated among high-quality large caps.

Therefore, Wilson still favors high-quality stocks, but he notes that opportunities are beginning to spread from the erstwhile strong large-cap quality stocks to some cyclical sectors where fundamentals remain healthy but stock prices have already corrected significantly. He is most optimistic about industrials, as the divergence between earnings expectations and stock performance has widened considerably.

Wilson specifically points to the capital goods segment within industrials, including sectors such as machinery, electrical equipment, aerospace, and defense. The earnings revision breadth for these capital goods industries has risen from 16% in February to 38% now, coming in just behind hardware and semiconductors. Meanwhile, their year-on-year stock price gains have fallen from 49% to just 10%. According to 30 years of historical data, at this level of earnings revision breadth, the stock price gains should be about 30% year-on-year.

This highlights a stark contrast: analysts are more optimistic about these companies’ earnings, yet stock performance continues to lag. Capital goods stocks are noticeably trailing improvements in fundamental earnings.

In addition to upgrades in analysts’ earnings expectations, another indicator of improving fundamentals is industrials' order activity. Backlogs in several manufacturing sectors, including machinery and metal products, are accelerating again, and ISM data show that more industries are experiencing increases in backlog orders. Wilson believes rising backlogs signal more secure future revenues. If companies also maintain pricing power, they can potentially translate higher volumes and prices into improved profit margins.

However, there is still a very important factor affecting stock prices: interest rates. Wilson argues that the stock market does not need rates to fall sharply—stabilization would suffice. If US Treasury yields stop rising, the pressure on stock valuations will ease, creating an opportunity for corporate earnings to once again drive stock prices.

As for oil prices, Morgan Stanley finds that for every 1% change in oil prices, the 10-year Treasury yield adjusts by about 0.9 basis points, which is close to the historical norm. So unless energy shocks turn into sustained inflation, there’s no reason to expect long-end yields to surge. Nevertheless, energy remains a key factor in policy path assessment.

Overall, Morgan Stanley judges that rate risk still remains, but it’s no longer as pressing as in previous weeks. The main risk now is another spike in bond market volatility, which could tighten liquidity and financial conditions, putting renewed pressure on equity valuations.

Morgan Stanley also mentioned last week that there are always two ways for the gap between indices and lagging stocks to close: either indices pull back, or the laggards catch up. Ultimately, which path prevails depends on the bond market.

In the past month, the US Treasury volatility index MOVE has jumped nearly 45%, suggesting the bond market has repriced for high rates, inflation, and policy uncertainty. In contrast, the S&P volatility index VIX has edged down, reflecting the US equity market’s relative calm.

This divergence is hard to sustain, since Treasury yields are the base for valuations. If rate volatility remains high for an extended period, companies’ discount rates, financing costs, and market risk appetite will all be affected, and the pressure will eventually transmit to equities. The good news is that today, MOVE fell by 7% and is currently hovering around 105. Historically, this level does represent a small spike, but it’s not excessive. Hopefully, this marks a good starting point.

The US investment team believes that if long-end yields can stabilize here and lead MOVE lower, at the very least, rate risk will not worsen further. In this scenario, stocks that have already been through a correction but whose fundamentals remain intact could see a rebound first. Market breadth could also improve from its previous record-poor levels—that is, more stocks would start to rise. Conversely, if the 10-year yield heads toward 5.5% and the 30-year toward 6%, then the high-quality, high-certainty AI cohort will continue to demonstrate stronger resilience.

Therefore, although we do not know how the bond market or the Middle East situation will evolve, it is clear that high-quality stocks will have better odds of outperformance.