Morgan Stanley: A catch-up decline in U.S. equity indices may mark the final stage of the correction, as earnings improvement spreads to more companies

Why might a catch-up decline in the indices mark the final stage of the correction?

Morgan Stanley previously judged that the mid-cycle correction would end with the indices converging toward weaker market breadth; the firm believes this process is under way, while conditions for ordinary stocks have improved.
The median company in the Russell 3000 Index has reached its strongest earnings-per-share growth in four years. However, the firm still wants further confirmation from its own sentiment indicators, and its year-end base case for the S&P 500 Index remains 8000 points.

Morgan Stanley expects earnings growth at the average company to accelerate, with market returns in 2026–2027 also broadening. Its non-PMI leading earnings model points to double-digit earnings-per-share growth.
The model uses macroeconomic data on economic activity, business confidence, wages and the monthly GDP cycle component to forecast earnings. At the same time, upward revisions to earnings estimates have been uneven: as of the end of October 2026, 2026 earnings estimates for S&P 500 companies had been revised up 17% year to date, while estimates for the S&P 400 and S&P 600 had each been revised up 8%.
Valuation remains a constraint: as of the end of October, the S&P 500 forward price-to-earnings ratio was 18.4 times, above the median of 16.2 times over the past four years; the U.S. equity risk premium measured by the firm was also near a historical low.

The firm believes financial conditions have already had a tightening effect to some extent, but Fed Chair Warsh is reluctant to describe financial conditions as directly restrictive, meaning the threshold for the Fed to shift to a more dovish stance remains high. Liquidity is a risk to watch as 2027 approaches.
Historically, large-cap stocks have risen by about 15% on average in the six months after midterm elections, with similar performance from market-cap-weighted indices and ordinary stocks. Morgan Stanley also notes that a renewed escalation of military conflict with Iran after the election, as well as tariff issues, are risks that merit closer attention.

Morgan Stanley is overweight industrials, financials and consumer discretionary, and underweight consumer staples and real estate. Its rationale is that a rolling recovery favors cyclical stocks, while industrial new orders and backlogs are improving, and capital expenditure growth is also supported by factors such as an earnings recovery and data-center construction.
The firm favors companies that consistently generate cash, have sound balance sheets and are seeing improving earnings expectations. Banks have seen improvement in prospective earnings growth and earnings-estimate revisions; consumer staples, meanwhile, face pressure from tariffs, commodity costs and weakness among lower-income consumers.