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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and chief U.S. equity strategist. Today in the podcast I'll be discussing the transition from early to mid cycle and what that means for your portfolio. It's Monday, July 27th at 11:30am in New York, so let's get after it. Our broadening call for the market has been about moving beyond the narrow leadership of the mega cap winners and into more economically sensitive areas. That made sense in the context of our rolling recovery thesis, a period when revenue growth returns to lean cost structures and operating leverage emerges across many sectors of the economy. But now I think that early cycle phase of the rolling recovery is ending and the market is starting to rotate toward quality. That's not bearish, but it is different and it can affect portfolios at the stock level. As the cycle matures, investors stop rewarding low quality beta and and start focusing more on free cash flow, balance sheet strength, margins and earning stability. The market is not abandoning the recovery, it's becoming more selective about the best way to own it. This setup reminds me of early to mid-2021. After the initial post Covid rebound, leadership shifted away from lower quality and more speculative areas and toward higher quality companies. The S&P 500 kept rising, but the leadership changed. I think we're seeing something similar today. The S and P itself is already quality heavy benchmark with high quality cohorts representing roughly 42% of the index versus about 28% for low quality. That should help keep the index resilient. Even as the market continues to digest this transition, could we still see near term volatility? Absolutely. If the war escalates further or the Fed surprises us with a rate hike this week, the market can continue to correct. I continue to think 7,000 the S&P 500 is important support if investors remain uneasy about the Fed transition or the geopolitical backdrop. However, the bigger message is that leadership is changing, not that the bull market is ending. One of the most important drivers of this shift is AI adoption. Earlier in the cycle, margin expansion was about classic operating leverage, sales recovering faster than costs. From here, margin expansion will depend more on companies using AI effectively running leaner and turning productivity into revenue growth as well. This is why quality matters. Companies with strong pricing power, strong balance sheets, or the ability to translate AI adoption into real growth are likely to be rewarded disproportionately. Companies where AI is material to the investment thesis and pricing power is neutral to strong are seeing forward net margin expectations improve nearly 400 basis points above the median stock. Our transcript work also shows that roughly 25% of S&P 500 companies cited measurable benefits from AI adoption in the second quarter, up from 14% a year ago. That's operating leverage with a new engine. This also feeds into the AI leadership rotation. I still think semis are likely to underperform hyperscalers from here, even if both can be under pressure during the next leg of consolidation. Semis are a classic early cycle group, and they've already seen a peak rate of change in earnings revisions. The hyperscalers, by contrast, have high quality core businesses, exposure to the agentic application layer, and an underappreciated ability to take costs out through AI driven efficiencies. In terms of the Overall S&P 500, the two variables I'm watching most closely are interest rates and oil. The bond market is pricing a meaningful probability of a Fed hike, but my base case remains that the Fed stays on hold. A hike would be a hawkish surprise and a risky maneuver, but I think even that would delay rather than derail a positive finish to 2026 with earnings growth remaining strong. Oil is the other wild card. A sustained rise in oil is not priced into equities and just another reason to move one's portfolio up the quality ladder. Bottom line, the broadening is not over, but it is changing shape and leadership. We're moving from early cycle beta toward mid cycle quality as the market seeks not only growth, but companies that can convert that growth into durable free cash flow and margin expansion. The recent elevation of quality factors has been evolving for the past month and now it's time to fully embrace it. Thanks for tuning in. I hope you found it informative and useful. Let us know what you think by leaving us a review, and if you find thoughts on the market worthwhile, tell a friend or colleague to try it out.
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