“# Weekly Warm-up: Enter Sandman We think the correction that began months ago is in its final phase, with the S&P 500 catching down as breadth improves, consistent with our call. We expect near-term clearing events to provide an attractive opportunity to add risk to quality cycli…”
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# Weekly Warm-up: Enter Sandman We think the correction that began months ago is in its final phase, with the S&P 500 catching down as breadth improves, consistent with our call. We expect near-term clearing events to provide an attractive opportunity to add risk to quality cyclicals that have de-rated as we head into 2027. \- The Index Catch-Down Is Likely the Final Stage of This Correction. We have argued that the mid-cycle transition would end with the index catching down toward weaker breadth, and that process is now underway even as the average stock improves. With 10-year yields declining, the equal weight S&P has outperformed the cap-weighted S&P and the lower quality Russell 2000 by 6% and 4%, respectively, since September—in line with our views. We are getting close, but would like to see either further confirmation from our sentiment indicator or the S&P 500 to reach our previously identified downside tactical target of 7100-7300 before adding risk more aggressively. Our year-end base case remains 8000 for the S&P 500. \- Financial Conditions Are Doing the Fed's Work; Liquidity Remains A Risk. Last week, Fed Chair Warsh acknowledged the tightening already delivered by financial conditions to some extent, but his comments suggest the bar for a more dovish Fed pivot remains high—i.e., he was unwilling to say financial conditions are outright "tight." A TGA drawdown from the Treasury into year-end could provide some relief should it play out as could less back-end issuance, making this week's Quarterly Refunding Announcement important. \- Midterms Should Help Clear Another Important Overhang. Historically, large cap stocks have gained approximately \~15% in the six months following midterms, with similar strength in both the cap-weighted index and average stock. A Democrat sweep is already anticipated by investors, although the magnitude of that sweep remains uncertain to market participants. Meanwhile, many of the policies most relevant to markets remain under the executive branch's control. The more notable risk comes post the election with the potential for renewed military escalation with Iran or tariffs. \- Earnings Season Continues to Favor Quality, Particularly Free Cash Flow. In line with our quality rotation call since July, the market is becoming more discerning as the cycle progresses, with free cash flow surprises driving larger next-day price reactions than EPS surprises. This reinforces our preference for companies with durable cash generation, strong balance sheets and improving earnings revisions. As we progress past the upcoming clearing events, the opportunity set is likely to become richer for quality cyclicals, in particular—Industrials remains our top pick, while more crowded areas of the index may still have some work to do on the downside as part of the final capitulation of this correction. Michael J Wilson Equity Strategist M.Wilson@morganstanley.com +1 212 761-2532 Andrew B Pauker Equity Strategist Andrew.Pauker@morganstanley.com +1 212 761-1330 Michelle M. Weaver, CFA Equity Strategist Michelle.M.Weaver@morganstanley.com +1 212 296-5254 Quantitative Strategist Qian.Ding@morganstanley.com +1 212 761-6758 Equity Strategist Nick.Lentini@morganstanley.com +1 212 761-5863 # Enter Sandman with Correction in Final Innings Given last week's price action, we think the correction that began in June is now in the final innings, with the S&P 500 and breadth meeting in the middle, as we expected. As is typical of mid-cycle transitions, the damage has been worst in early cycle groups, with Semiconductors, Capital Goods, Transports, Banks and Retailers falling materially from their summer peaks. Importantly, breadth has been improving more recently as the still crowded areas like parts of cyclical tech catch down—part of the capitulation process. Since the end of September, 10-year Treasury yields have declined by nearly 40bp, while the percentage of S&P 500 stocks above their 200-day moving average has risen \~20 percentage points to 62%. Over the same period, the equal-weighted S&P 500 has gained nearly 5%, outperforming the cap-weighted index by almost 6%. This supports our view heading into October that back-end yields were likely approaching a peak, and that the equal weight S&P was the more attractive expression of the broadening trade. The lower quality Russell 2000 likely needs a bigger decline in rates than what we've seen already, while the equal weight S&P can work with more of a stabilization in the long end. While we still think a final capitulatory event is possible, particularly with our Market Sentiment Indicator (MSI) not yet at levels that typically mark the end of corrections, the price action last week suggests we are getting close. Exhibit 1: Breadth Has Improved Materially As the Cap Weighted Index Has Consolidated  Source: Bloomberg, Morgan Stanley Research. Exhibit 2: Our Composite Sentiment Indicator Is Nearing Capitulatory Levels, but Not Quite There, Yet  Source: Bloomberg, Morgan Stanley Research. Warsh's comments at last week's FOMC meeting included some acknowledgment of the tightening in financial conditions we have been highlighting, but they still centered on the continuing efforts to combat inflation. Importantly, Warsh distinguished between financial conditions being "tighter" and actually being "tight," suggesting he remains comfortable with the adjustment underway. The most important aspect of Warsh's comments, from our perspective, was that he did not double down on his message from Jackson Hole that the market interpreted as an effort to get inflation to target quickly. Thus, the Fed has flexibility to pause for now, although the bar for additional liquidity support still appears relatively high. In our view, liquidity may be tighter than was acknowledged last week, so this particular clearing event may still have some work to do. One potential source of relief, even without a change in Fed policy, is the expected reversal of Treasury's recent cash buildup. Since mid-July, the Treasury General Account (TGA) has increased approximately \$244 billion, alongside a \$249 billion decline in bank reserves, while Fed assets have remained essentially unchanged. Treasury anticipated this buildup, projecting a late-October TGA peak near \~\$1.05 trillion followed by a decline toward \~\$850 billion by year-end. A more material drawdown in the TGA would be welcome should it play out given slower Fed balance sheet growth and the economy's significant demand for capital. One key question is whether the expected drawdown also coincides with less restrictive financial conditions more broadly across rate and energy markets. If it doesn't, markets may ultimately need more liquidity from the Fed. Another question for financial markets is what form does it take this time—is it an orderly and proactive response from the Fed like last year or something more disruptive like in 2018? In short, last week's Fed meeting was not a full clearing event for liquidity and may require more pressure to resolve or simply a curtailment of the heavy supply of issuance that still lies ahead. The midterms represent the most obvious clearing event we discussed in last week's note, with history providing an encouraging signal. Since 1982, large cap stocks have gained approximately 15% on a cap-weighted basis and 16% on an equal-weighted basis in the six months following midterms, with both measures rising roughly 22% over the subsequent year. A Democrat sweep via a narrow Senate majority is anticipated by investors and therefore unlikely to be a major market surprise, while a much more decisive Senate victory would potentially push the equity market to look further out to 2028 in terms of pushback against deregulation. With that said, many of the policies that have moved markets most over the last 2 years, including tariffs, foreign policy and agency-led deregulation, remain largely under executive branch's control, and equities typically don't think 2 years ahead very often or for very long. On the data center front, opposition to data center development is often driven more by local incumbent dynamics than party affiliation. There are also potential upside risks from a Democrat majority, including efforts to delay or reverse Medicaid and SNAP cuts that could support consumption. Further, the prospect of a different policy environment in 2028 could pull forward some investment and M&A activity. We think the more significant risk is the potential for renewed military escalation with Iran or additional tariffs after the election, particularly if higher energy prices push inflation expectations and long-end yields higher in the former risk scenario. Exhibit 3: Midterm Seasonality Average Top 1000 Equal Weighted Performance (Relative) around Midterm Election Year by Industry Group since 1982 Prior 9M Prior 6M Prior 3M Next 1M Next 3M Next 6M Next 9M Next 12M Energy 1.5% 2.4% -0.3% -0.5% -7.8% -8.2% -9.2% -10.7% Materials -0.5% -1.8% 0.0% -1.2% -0.1% 0.7% 0.7% 0.1% Capital Goods -1.2% -2.7% -0.5% 0.1% 0.6% 0.7% 4.2% 2.8% Commercial & Professional Services 0.1% 1.2% -0.2% -0.4% -0.6% -1.3% -3.3% -3.4% Transportation -3.7% -4.2% -2.9% 1.1% 0.9% 0.7% 1.0% -1.2% Automobiles & Components -3.0% -4.2% -2.7% 1.0% 1.9% 0.1% 4.0% -0.3% Consumer Durables & Apparel -2.9% -3.6% -3.0% 0.1% 2.3% 2.6% 2.5% -0.1% Consumer Services -1.9% -3.5% -2.2% 0.3% 1.3% 5.2% 7.0% 5.1% Consumer Discretionary Distribution & Retail 3.6% 1.6% 0.2% 0.9% 2.9% 6.5% 7.3% 4.4% Consumer Staples Distribution & Retail 9.5% 6.7% 2.5% 1.3% 2.1% 0.7% -0.5% -0.7% Food, Beverage & Tobacco 8.7% 7.0% 1.3% 1.3% -0.4% -3.5% -5.2% -2.6% Household & Personal Products 3.1% 3.2% -0.4% 1.5% 2.2% 4.3% 0.8% 1.1% Health Care Equipment & Services 7.0% 6.2% 3.0% -1.0% -0.2% 2.9% 0.6% -3.1% Pharmaceuticals, Biotechnology & Life Sciences 8.5% 7.9% 5.0% 0.8% 0.8% 3.9% 2.7% 3.9% Banks -0.7% -1.8% -2.4% -1.7% -3.5% -8.3% -9.7% -8.8% Financial Services -1.5% -2.1% -0.6% 2.2% 2.4% 6.2% 7.2% 5.7% Insurance 1.2% 0.1% 0.0% -1.1% -0.9% -4.2% -7.7% -6.6% Software & Services -2.6% -1.7% -0.2% 2.4% 6.0% 11.3% 14.7% 17.4% Technology Hardware & Equipment -5.9% -3.9% -0.7% 2.6% 6.6% 10.9% 14.6% 16.8% Semiconductors & Semiconductor Equipment -5.5% -9.3% -4.1% 3.7% 8.4% 21.7% 32.6% 39.5% Telecommunication Services 1.7% 3.6% 2.3% 2.3% 2.2% -2.1% -2.1% -1.5% Media & Entertainment -1.2% -0.1% 0.2% -0.2% 0.2% 1.6% 3.7% 2.7% Utilities 5.1% 5.2% 2.8% -0.3% -0.9% -7.2% -10.9% -7.3% Equity Real Estate Investment Trusts (REITs) 3.2% 2.8% 0.5% -1.7% -2.3% -4.2% -8.4% -8.1% Real Estate Management & Development -5.7% -8.3% 2.3% -3.7% -3.9% 3.3% -4.0% -21.9% Top 1000 (Cap Weighted) -1.4% -3.0% -1.1% 4.0% 7.0% 15.3% 22.2% 21.9% Top 1000 (Equal Weighted) -2.8% -5.1% -2.6% 3.6% 7.2% 16.4% 23.8% 22.4% Value vs Growth 4.1% 1.6% 0.5% -0.8% -1.9% -6.0% -6.7% -6.7% Quality vs Junk 6.7% 7.1% 2.4% 0.5% 0.2% -4.7% -6.4% -5.7% Cyclical vs Defensive -5.2% -6.2% -3.0% 0.5% 1.1% 4.1% 7.4% 5.7% Small vs Large -3.2% -4.9% -4.1% -1.0% 0.0% 2.7% 3.6% 2.1% Source: Compustat, Morgan Stanley Research A few risks have weighed on the cap-weighted index recently, facilitating this latest catch down in S&P 500 performance toward improving breadth. These variables include the pace of AI-related capex, credit spread widening in certain segments of the AI trade, tighter liquidity, uncertainty around the Middle East situation and the upcoming midterm elections. While the second derivative on EPS growth is expected to slow into next year, this is not the primary driver of last week's price action, in our view. Historically, equity markets continue to show strength even as the rate of change on growth slows as long as it's still above 0%—leadership, though, shifts to high quality. What tends to impact economically sensitive sectors more in this type of environment is rapid increases in the cost of capital. Cyclical areas were the first to price the most recent adjustment in cost of capital from Jackson Hole to the beginning of October. Since the beginning of October when yields topped, the equal weighted S&P (a higher quality expression of breadth) has surged back as shown above. Credit spreads also feed into that cost of capital dynamic and have been in focus recently for investors from a risk standpoint. In our view, credit markets have become more discerning about issuance, although demand remains solid for IG issuance, and hyperscaler supply is still a relatively small share of the market. We view this as consistent with the greater differentiation on quality as both the business and AI investment cycle mature, rather than evidence of a broader credit problem. Finally, 3Q earnings season continues to reinforce the market's preference for quality even as the high quality indices (SPX and NDX) underperform the average stock. For the record, this is what we expected and noted in recent research so that makes us feel more confident we are closer to the end of this correction. Free cash flow (FCF) surprises are driving larger next-day price reactions than EPS surprises, with the largest FCF beats generating meaningful upside and misses being penalized more heavily than has typically been the case. While a similar pattern is evident for EPS, the response to FCF surprises has been more pronounced relative to history. Investors are no longer overlooking FCF shortfalls as they often did earlier in the cycle, consistent with a more typical mid- to late-cycle environment where earnings durability and cash conversion matter more. This supports our continued preference for quality, including higher-quality cyclicals with improving earnings revisions. As the remaining policy and liquidity uncertainties clear, we think the opportunity to add risk more aggressively is approaching, with earnings growth ultimately reasserting itself as the primary driver of returns. Exhibit 4: Quality in Focus As FCF Is Driving Price Action More than EPS  Source: FactSet, Morgan Stanley Research Exhibit 5: Stocks Are Sensitive to FCF Misses This Quarter  Source: FactSet, Morgan Stanley Research Bottom line: over the last month, we've conveyed the view that index and breadth were likely to converge as yields topped—Exhibit 1. Now we are seeing the leadership of the market catch down, which is typically the last phase of a correction. This one started several months ago and is in its final innings, from our perspective. One stat that's pretty striking is that $60\%$ of Russell 3000 stocks have already seen at least a $20\%$ correction since June, while the P/E multiple for the S&P 500 has declined by $20\%$ from its high a year ago. Upcoming clearing events should provide an opportunity to add risk to quality cyclicals that have de-rated significantly already. ## Earnings Season Chartbook \- Median T+1 price reaction is at +0.1% on an absolute basis and +0.4% on a relative basis. \- EPS surprise at 4% which is slightly below the historical average and well below recent quarters. Sales surprise at 2.0% which is above the historical average of +1.3%. • 3Q EPS is expected at +28% Y/Y and sales at +12% Y/Y. \- Earnings Revision Breadth is at+7%, which is lower than the previous 6-month level. ERB has not rebounded as strongly during 3Q EPS season which suggests upward revisions to 2027 have slowed this quarter. We think this slowing in estimate momentum alongside FCF surprise have been key drivers this earnings season. • Calendar 2026/2027 earnings growth is now 32%/16%. \- Mag 7 earnings are expected to grow 25% in 3Q26 vs. 22% for the SP493, both historically strong. For 2027, this flips and has the SP493 growing 17% vs 12% for the Mag 7 but this is largely on difficult comp effects for the Mag 7 from one-off benefits (non-operating income). \- Analyst previews are positive but less so than last quarter. Net EPS previews are +21% versus +27% for NTM EPS last quarter. Results have been similar at +15% vs +30% in 2Q. ## Key Charts Exhibit 6: 3Q Reporting Season by Market Cap S&P 500 Earnings by Market Cap Reporting - 3Q26  Note: Includes 451 of S&P 500 companies and 92% of S&P market cap reporting from Oct. 5 to Nov 27th Source: Bloomberg, Morgan Stanley Research Exhibit 7: 3Q Reporting Season by Company Count # of Companies Reporting - 3Q26  Note: Includes 451 of S&P 500 companies and 92% of S&P market cap reporting from Oct. 5 to Nov 27th Source: Bloomberg, Morgan Stanley Research Exhibit 8: Forward SPS and EPS Expectations  Source: FactSet, Morgan Stanley Research Exhibit 9: Operating Leverage is Set to Expand in 2026  Source: FactSet, Morgan Stanley Research Exhibit 10: 3Q Estimates Push Higher into EPS Season  Source: FactSet, Morgan Stanley Research S&P 500 EPS Growth from Top-Line Growth and Margin Expansion Exhibit 11: EPS Growth is Coming from Both Top-Line Growth and Margin Expansion  Source: Refinitiv, Morgan Stanley Research Exhibit 12: Blended Next 12M Earnings Rising Further  Source: FactSet, Morgan Stanley Research Exhibit 13: 2026/2027 EPS Estimates Continue to Revise Higher  Source: FactSet, Morgan Stanley Research Exhibit 14: AI vs Non-AI Related Names within S&P 500  Source: FactSet, Morgan Stanley Research Exhibit 15: Mag 7 vs SP493 Earnings Growth  Source: FactSet, Morgan Stanley Research Exhibit 16: Mag 7 vs SP493 Annuals: SP493 is now Higher in 2027  Source: FactSet, Morgan Stanley Research Exhibit 17: Contribution to S&P 500 Earnings Growth % of Net Income Growth  Source: FactSet, Morgan Stanley Research Exhibit 18: S&P 500 earnings are being skewed by unrealized gains in AI investments...  Source: FactSet, Morgan Stanley Research Exhibit 19: ...and accelerated 1Q/2Q earnings are affecting forward growth rates  Source: FactSet, Morgan Stanley Research Exhibit 20: 2026 Net Income Revisions  Source: FactSet, Morgan Stanley Research Exhibit 21: 2027 Net Income Revisions  Source: FactSet, Morgan Stanley Research Exhibit 22: Median Sales Growth is Strong  Source: FactSet, Morgan Stanley Research Exhibit 23: Median EPS Growth is Accelerating  Source: FactSet, Morgan Stanley Research ## Scorecards Exhibit 24: Earnings Scorecard Sector S&P 500 3Q26 Preliminary Earnings Analysis # Reported # Cos Rptd % of Cos Rptd % …
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市场广度指标显著改善：200日均线以上股票占比升至约62%，等权重指数开始跑赢市值加权指数。；Warsh对金融条件收紧的表述没有进一步强化紧缩立场，美联储仍可暂停，但提供额外流动性的门槛较高。