Digital darling stocks are not necessarily riskier than blue chip names despite their reputation

One of the favorite pastimes of market watchers is predicting the next seismic shift in investor preference. The latest trendy forecast goes something like this: We've had a major pivot from the digital darling FAANG stocks to the rejuvenated "Blue Chips" of 2018. However, finding evidence of this type of leadership swap in history is far from obvious.

The FAANG terminology, while catchy, is too narrow for this particular exercise. The Nasdaq Composite index, in which these five stocks represent 26 percent, and technology or internet names account for roughly 60 percent of the market value, has been the strongest of the major US indices over the past several years.

For the purpose of this exercise, the Dow Jones Industrial average, with its broad diversity across major industry sectors, including such names as Caterpillar, Walmart, Boeing, United Technologies, Pfizer, Disney, and Nike, is a proxy for the Blue Chips.

On a price basis, the Dow advanced an outstanding 9.0 percent in the third quarter of 2018 compared to a very healthy 7.1 percent for the Nasdaq Composite index, for an outperformance of 1.9 percent. If we review the past 10 years of data (see exhibit below), the Dow has beaten the Nasdaq by that amount or more only 25 percent of the time. Furthermore, the two consecutively strongest relative quarters were the third and fourth of 2008, and we know what happened then.

Source: FactSet

The past five years presents a similar picture, in which the Dow hit only one two-hit streak against theNasdaq, in the first half of 2016. Otherwise, we have witnessed a tech/internet/small cap driven market with the Nasdaq up 113 percent cumulatively over this period versus 74 percent for the Dow.

So what might have changed so much to warrant the super pumped excitement about Blue Chips and belief that this Dow rally has legs?

Dow stocks appear cheap

The Dow stocks are trading at a sharp 38 percent discount, on a price to earnings multiple, at 15.9 times consensus for the next twelve months' earnings, versus 25.5 times for the Nasdaq. However, the Nasdaq companies are expected to grow earnings 21 percent in the next year, compared to only 11 percent for the Dow. Investors consider the price over the growth rate, and that ratio is lower for the Nasdaq, at 1.2 times, than the Dow stocks, at 1.4, equalizing what looked like a bargain price for the Industrial Average.

Could it be that if GDP continues its strong run into 2019, the Industrials is the better index in which to invest? Over the past decade, there have been thirteen quarters of domestic growth above 3 percent. During the seven observations within the last five years, the Dow underperformed the Nasdaq each time. Within the prior five years, the DJIA outperformed in four of the six quarter of 3 percent-plus GDP. Can we read a pattern into that? Doubtful.

Even looking for correlations that lag strong GDP results by a quarter or two fails to confirm any predictive relationship between the Dow and the Nasdaq.

Logic might suggest that the DJI, heavy with industrials and multi-nationals, who buy, sell, and move physical goods across borders and own factories and offices worldwide, would suffer more from trade tariffs than tech companies who can operate their digital global platforms from Silicon Valley. The smart money may be betting that overwrought concerns created a buying opportunity.

Perhaps, instead of being driven by a strong economy, cheap relative valuation, or relief regarding trade wars, investor affinity for Dow stocks is propelled by defensiveness.

The Dow dividend yield is 2.1 percent compared to 1.1 percent for the Nasdaq. Not a huge difference, but more than anyone is getting on their checking account.

In terms of whether owning the Blue Chips is protection against a very tough market, we looked at the data. There have been six quarters in the past ten years in which the broad market, in the form of the S&P 500, has fallen over 5%. How did the Dow stocks handle the deluge?

In four of the six examples, the Dow outperformed its riskier colleague index. But if you examine the average decline of the Dow during all those periods it was negative 11.1 percent. The average drop for the Nasdaq was negative 11.5 percent. What can we learn from that?

I would argue that we cannot infer from the data that the Blue Chips are poised for a sustained period of outperformance relative to the higher growth Nasdaq index, unless the market takes a very sharp decline. As a Red Sox fan, I'd rather root for the Yankees than wish for that to happen. Well, maybe that's asking too much.