Wall Street stock strategists have a new favorite word

Wall Street always seems to have a new favorite word or phrase.

When the AI trade launched in earnest, it was the “Magnificent Seven.” Then came “AI enablers,” “picks and shovels,” and, more recently, “momentum.”

Now, as investors fret over rising interest rates, expensive AI ambitions, and a top-heavy market, the word du jour is “quality.” In a stock-market context, it refers to companies with strong and durable earnings, balance sheets, pricing power, and cash flow.

Morgan Stanley has been beating the drum for a while. The firm’s thesis is that the market is in the middle of a recovery cycle — a more selective, less speculative environment that favors quality.

Goldman Sachs added its own spin on the quality recommendation this week, highlighting it as an attractive option if the market’s winners suddenly draw down.

The beauty of quality stocks is that they’re not necessarily traditional defensive plays. They can also include AI-trade participants — just with a higher bar for entry. These are companies that can weather sentiment downturns by leaning on the strength of their existing businesses.

Quality has been pulling away

Quality stocks aren’t just attractive for future upside. They’ve been walking the walk for a few months.

Morgan Stanley says its proprietary quality index — which you can get a peek inside here — has gained 6% since mid-August, while the equal-weight S&P 500 has slipped 4%.

The chart below shows this dynamic in action over the same time period, substituting the GMO US Quality ETF (QLTY) in for Morgan Stanley’s quality gauge. It’s not the same makeup, but it’s still been handily outperforming — and avoiding losses.

AI can join the party

There’s one version of the high-quality trade that involves dumping the more speculative corners of the AI trade (think chipmakers) and buying traditional defensive stocks (like consumer staples).

But that’s boring. The more interesting version is one that involves selective AI ownership. It really boils down to two camps: (1) companies funding expansion using existing profits and balance sheets and (2) firms dependent on debt and capital markets.

Big hyperscalers fit into the first group. They can spend aggressively without becoming an existential financing story. And wouldn’t you know it, Microsoft, Alphabet, and Meta account for three of QLTY’s four largest holdings.

That makes Meta’s earnings after today’s close a timely test of the overlap between quality and AI. Its enormous spending plans look very different from a debt-fueled data-center gamble (cough, CoreWeave, cough). That’s because Meta can fund them with its immensely profitable advertising business.

That self-sustainability is becoming an increasingly important dividing line in the AI trade. A strong balance sheet can get a company into the quality club, but results are what keep it there.