New quality factor guidance layout, MS.US (MS.US) Wilson: The adjustment is coming to an end

According to Woofun AI, Morgan Stanley (MS.US) chief stock strategist Michael Wilson sent a clear signal that months of internal stock market adjustments are coming to an end, and investors should be prepared to increase their risk exposure. This judgment is based on the triple signals that quality factors have broken through to new highs, profit revisions have intensified, and valuation has been drastically absorbed, providing a rare layout window for the market.

The deterioration in market breadth is simultaneously showing signs of a mid-cycle transition. Although the S&P 500 index is only about 2% away from its historical high, the market breadth within the index has deteriorated significantly. The weighted version has accumulated a cumulative decline of nearly 4% since the August 14 high, and cyclical sectors such as finance, industry, and non-essential consumer goods have borne the main impact of valuation compression.

This pattern of differentiation is a typical characteristic of the market's transition from an early cycle to a mid-cycle. Wilson said, “We recommend investors be prepared, whether for a quick recovery or to endure downward pressure that continues more slowly until November, because in our view, it will be a time to increase risk (positions) rather than avoid risk.” Meanwhile, Goldman Sachs (GS.US) strategists note that investor positions are becoming defensive, and JPMorgan Chase (JPM.US) believes that stabilizing bond yields will form “important support” for the stock market.

The quality factor has broken through, and the mid-cycle transition signal is clear. The Morgan Stanley (MS.US) Quality Factor Composite Index has risen to a 52-week high, with a cumulative increase of about 6% since mid-August, while the equal-weighted S&P 500 index fell nearly 4% during the same period. Wilson believes that this divergence is a clear confirmation of the market's shift from early cycle low-quality stocks leading gains to mid-cycle high-quality stocks dominating. Revised earnings data further strengthened this judgment. The gap in the breadth of earnings revisions between high-quality and low-quality stocks has widened to about 10%, the second-highest level since 2010. Historical data shows that when the gap was at the highest five-point in history, high-quality stocks outperformed low-quality stocks by an average of about 8% over the next 12 months, while the average excess return for all periods was only about 1%.

Notably, the current relative forward price-earnings ratio of high-quality stocks is still close to the historical median, and investors do not need to pay an additional premium for this profit advantage.

Wilson traced the beginning of this cycle shift to “Liberation Day” in April 2025, which marked the end of the rolling recession and the beginning of a new economic cycle. In June, he identified that the rate of change in the breadth of profit revisions for low-quality early-cycle leading stocks (semiconductors, non-essential consumer goods, finance) peaked. Combined with the more hawkish policy approach brought about by the new chairman of the Federal Reserve, they jointly confirmed the arrival of the mid-cycle transition.

Financial conditions have been tightened, and cyclical stock valuations have been fully digested. The financial conditions index based on Morgan Stanley's (MS.US) composite interest rate, dollar, and energy prices has tightened to the highest level since 2022, and the impact on economy-sensitive stocks is particularly obvious -- since mid-August, the financial, materials, non-essential consumer goods, and industrial sectors have all performed significantly under the general market under equal weights. Wilson pointed out that the key variable now is how Federal Reserve Chairman Warsh characterizes this tightening of financial conditions. Warsh previously attributed the rise in long-term yields mainly to strong economic growth, capital competition, and geopolitical factors. If Warsh admits that the market has replaced the Federal Reserve to a certain extent and completed austerity work, the pressure on interest-sensitive assets may ease; conversely, if it continues to focus on the risk of inflation and ignore the effects of the tightening that has already occurred, long-term yields and cyclical stocks may continue to be under pressure.

Warsh did not provide new monetary policy guidance at the IMF meeting, and the market interpreted it as being basically consistent with previous pricing. Morgan Stanley (MS.US) economists expect the Federal Reserve to keep interest rates unchanged in October.

The profit fundamentals are steady, providing momentum for the layout. Strong profit prospects underpin current market confidence. According to Bloomberg Intelligence estimates compiled by Bloomberg, the third-quarter earnings of S&P 500 components are expected to increase by about 24.6% year over year.

According to data compiled by Woofun AI, according to Morgan Stanley (MS.US) data, EPS is expected to increase 27% year-on-year in the third quarter, and the EPS growth rate for 2026 and 2027 for the whole year is 33% and 16%, respectively.

AI-related stocks are the main driver of earnings growth. Morgan Stanley (MS.US) estimates that the total AI capital expenditure of hyperscale cloud computing companies and emerging cloud service providers will reach 1.58 trillion US dollars in 2027, of which about 65% will flow into S&P 500 companies, directly contributing about 5% of S&P 500's revenue and about 25% revenue growth. The profit growth rate for AI-related companies is expected to reach 25% in 2027, compared to just 4% for non-AI companies.

Looking at the current earnings season, the median share price response the next day was -0.4% of the companies that have reported about 10%. Only 41% of companies recorded a positive response, and the market's tolerance for performance declined. A forward-looking preview from Morgan Stanley (MS.US) analysts showed that the KPI net positive forecast was +18%, and the NTM EPS net positive forecast was +15%, both lower than the level of the previous quarter, but the overall value remained positive.

Layout direction: Quality first, focus on high-quality cyclical stocks such as capital products. Wilson maintains a preference for quality stocks, while pointing out that valuation digestion has created more attractive entry opportunities in some cyclical sectors. He specifically named the capital goods sector, believing that the breadth of profit revisions in this sector is improving, in line with the broader manufacturing order backlog trend.

The “high quality+profit correction” stock pool selected by Morgan Stanley (MS.US) covers multiple industries, including Apple (AAPL.US), Broadcom (AVGO.US), Micron (MU.US), etc. in the information technology sector, all of which meet the screening conditions for the top 1000 market capitalization, the top quartile of the overall quality score, the recent NTM EPS increase, and the Morgan Stanley (MS.US) shareholding rating.

Wilson said that under the benchmark scenario, stabilizing long-term yields will once again make profits the main driving force for returns; even in a risk scenario where financial conditions continue to tighten, quality stocks can historically provide relative protection. He listed whether the relative performance of the financial sector can stabilize during the earnings season, whether bond volatility can continue to decline, and Warsh's statement on the tightening of financial conditions as the three key indicators for judging whether this round of adjustments is actually over.