Morgan Stanley says the stock market's big losers are about to play catch-up. Here's how to position for the rally.

Things are about to get brighter for investors after enduring an extended rough patch in stocks that’s seen most of the S&P 500 struggle this year, Morgan Stanley says.

Since June 2, the S&P 500 has been flat. The last month has been particularly bumpy for the market, with the benchmark index falling as much as 3% since October 6, while the tech-heavy Nasdaq 100 has lost 9%.

Last Friday, selling intensified as the S&P 500 and the Nasdaq both plunged amid investor concerns about AI spending, future demand, and earnings uncertainty.

But in a client note on Monday, the bank said the downside would soon be over.

“Given last week’s price action, we think the correction that began in June is now in the final innings,” Mike Wilson, the bank’s chief investment officer, wrote in the note.

Wilson and his team listed several events unfolding in the market that should clear the outlook for stocks and allow for a rebound:

• The market’s top names are starting to feel some downside pressure, following a sell-off in other pockets of the market. This is often the last stage of a correction, the bank said. Investor sentiment souring a bit more would likely be enough to signal a reversal is on the way.
• Fed hawkishness may be cooling. The central bank kept rates unchanged in October, with Fed chair Kevin Warsh saying tightening financial conditions have done some of the job for the central bank. Still, the bank said there’s a high bar for Fed rate cuts.
• Treasury yields are falling, with 10-year yields down 40 basis points over the last month.
• The Treasury General Account could start to drain its cash reserves of around $1 trillion to buy bonds, providing liquidity to investors and potentially lowering interest rates.

• Market breadth is improving. 62% of stocks in the S&P 500 are trading above their 200-day moving averages, up from about 42% a month ago.

• Midterm elections this week should clear up overhanging uncertainty around which party will control the two houses of Congress. “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,” the bank said.

Still, the bank said investors aren’t totally in the clear year, and that further downside could remain for the S&P 500 before a rally begins.

“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,” Wilson said. “Our year-end base case remains 8000 for the S&P 500.”

As of Monday afternoon, the S&P 500 traded at 7,596.

How to position for the rally

To position for the eventual rebound, Morgan Stanley touted quality cyclical stocks, which the bank said have “de-rated significantly,” meaning they’ve become heavily out of favor.

The quality factor refers to companies with high free cash flow, stable earnings growth, a competitive advantage, and strong balance sheets. Cyclical stocks are those that tend to do well when the economy is growing.

The bank said the sector offering the most exposure to this theme is industrials, and labeled it its top pick. Industrials stocks on Morgan Stanley’s “Fresh Money Buy List” — which has outperformed the S&P 500 since early 2020 — include Delta Air Lines (DAL), Knight-Swift Transportation (KNX), and Northrop Grumman (NOC). Their upside to Morgan Stanley’s price targets, respectively, are 55%, 64%, and 38%.

For more diversified exposure to the trades listed above, examples of relevant exchange-traded funds include the iShares MSCI USA Quality Factor ETF (QUAL) and the Vanguard Industrials ETF (VIS).