Morgan Stanley strategists say investors should continue holding high-quality US stocks with steadily improving earnings per share ahead of the earnings season.

The team led by Michael Wilson said that valuation downgrades have created better entry opportunities for high-quality cyclical stocks.

"The relative performance of the financial sector may be the most important factor determining the short-term direction of the stock market," the report said. As the pullback continues, the range of investment opportunities within quality stocks is expanding.

A research report released on October 12 showed that the coverage of earnings upgrades in the capital goods sector rose from 16% in February to nearly 40%.

The report pointed out that the market is increasingly favoring targets with earnings upgrades, free cash flow, and resilient earnings.

The risk lies in another surge in real yields triggering sharp volatility in the bond market, rather than the current level of yields. The team believes there is a significant risk: high interest rates will evolve from a valuation issue into a growth issue.