Morgan Stanley's US equity strategy team told clients to buy cyclical stocks in a note published Monday, naming industrials the best risk/reward in the market.
The call rests on a gap between index levels and what's happening underneath them. Strategists said 54% of Russell 3000 stocks have fallen more than 20% since June.
The S&P 500 forward price-to-earnings multiple is back near 19 times, around its March lows. Earnings per share growth, meanwhile, remains in the mid-teens, with more analysts raising estimates than cutting them.
"That combination suggests the derating is much further advanced than the index price level alone would imply."
Michael Wilson, Morgan Stanley
Derating happens when a share price falls while underlying earnings hold up, pushing the multiple lower.
The damage is concentrated in smaller names
The S&P 500 has gained nearly 13% so far in 2026, masking the selloff beneath it. Independent market data backs the split. Among stocks under $2B market cap, 57% are in a bear market, versus just 22% for companies worth over $300B.
The Russell 2000 sits 8.5% off its high while the Nasdaq 100 trades near its peak. The VIX fear gauge is just 16, even as more than half of the 5,000-plus stocks tracked sit 20% or more below their highs.
Capital goods lead the earnings revisions
Wilson's team singled out capital goods for having among the strongest earnings revision profiles across industries.
"Parts of the asset-heavy universe are beginning to look more interesting."
Michael Wilson, Morgan Stanley
The argument is that years of investor preference for asset-light, services-oriented businesses left heavy industrials cheap relative to their fundamentals.
Carlisle Companies, Caterpillar, and General Dynamics were among the top stocks flagged within industrials.
A broader Morgan Stanley Research screen pulled 15 industrial stocks that rank in the top tercile of its quality universe. Each saw forward EPS estimates improve since late June and still fell more than 10%.
That list includes EnerSys, Leonardo DRS, Powell Industries, Booz Allen Hamilton, Waste Management, and Paychex.
None of the 15 carries a bullish Seeking Alpha Quant Rating. All are rated Hold. The backdrop is a rally that stalled in mid-August as rising bond yields offset one of the strongest earnings seasons on record.
Analysts expect S&P 500 profits to jump 25% in the July-September period from a year earlier, after a 34% surge in the prior quarter, per Bloomberg Intelligence.
AI demand, record hyperscaler capital spending, and a firm macro backdrop drove that growth. Wilson warned those expectations are creating a high bar for companies reporting third-quarter results in the coming weeks.
Earnings quality, free cash flow, and revisions breadth will be the key differentiators, his team said. For investors, the trade hinges on whether cheap industrials stay cheap or the index catches down to the average stock.
