Financial stocks are still being woefully underappreciated by investors, Morgan Stanley says

• Positioning in financial stocks is light relative to other sectors, Morgan Stanley says.
• They see the group as underappreciated, and cite its exposure to ongoing economic strength.

Investors are lingering in defensive trades that don't take advantage of the economy's ongoing strength, Morgan Stanley said, highlighting opportunities in underinvested sectors.

The firm — which just last week upgraded cyclical stocks to "overweight" relative to defensives — highlighted the financials group as particularly attractive.

Morgan Stanley said net exposure to financials is in the bottom 15th percentile of a historical data series that that goes back to 2010. And as the chart below shows, it's also the most lightly owned of any sector.

But Mike Wilson, the bank's CIO and chief US equity strategist, sees a combination of headwinds that could lift financial stocks.

"In our view, this creates opportunity in [the financial] sector that we upgraded to overweight last week given: rebounding capital markets activity, a better loan growth environment in 2025, an acceleration in buybacks post Basel Endgame re-proposal, and attractive relative valuation," he wrote.

Bank stocks also have more attractive valuations after de-risking last month after large-cap dealers signaled caution on their operating environment in September. Morgan Stanley noted that this weakness lowered earnings-season expectations for investors, making it easier for major lenders to outperform forecasts.

JPMorgan and Wells Fargo have jumped since publishing better-than-expected earnings reports last week. Since Friday's open, these banks are up 3.8% and 8.8%, respectively.

Despite this, the market's appetite for financials hasn't yet materialized, Wilson found. But this isn't just limited to bank stocks — investors are also passing up on other cyclical sectors, concentrating exposure in defensive and quality names.

Utilities, healthcare, and real estate — which are defensive plays — are among four sectors with the highest net exposure.

According to Wilson, this shows that investors are still positioning themselves for a soft-growth scenario, which seems less likely given in light of recent macroeconomic trends.

Though Morgan Stanley moved to neutral on cyclicals versus defensives late last month, it upgraded cyclicals to overweight last week after September's jobs report surged past Wall Street forecasts.

"As several key macro data points have come in better than expected (namely the jobs report and the ISM Services Index) following the Fed's 50bp rate cut, cyclicals have begun to show relative strength," Wilson said.

At the same time, rates market yields are moving higher, indicating that growth concerns are falling.

According to the note, cyclicals such as industrials, financials, and energy move up when yields rise, whereas defensive stocks are negatively correlated to higher rates.