Of the three major U.S. stock indexes, the Nasdaq (^IXIC -1.15%) has had by far the worst performance thus far in 2022. All of them have rebounded notably from their 52-week lows, but the tech-heavy index is still down 27% year to date, while the Dow Jones Industrial Average (^DJI -0.12%) is down by just 5% and the S&P 500 (^GSPC -0.58%) is off 14%.
Data by YCharts.
That's the biggest gap between the Dow and the Nasdaq since 2000.
Tech stocks came into 2022 looking overvalued. Sectors like software were trading at sky-high multiples. But in this uncertain market, investors have pivoted instead to blue chip stocks and dividend payers to ride out the volatility.
However, in 2023, there seems to be a good chance this trend will reverse, and the Nasdaq will beat the Dow. Here's why.
Growth stocks rebound first
It's impossible to know when the market will bottom, but when it does, growth stocks are almost certain to rebound before their slower-growth counterparts.
Investors tend to pile into growth stocks at the beginning of bull markets, because those stocks are the ones that fall the furthest in bear markets, and therefore have the most to gain in recoveries. We already got a taste of this process just weeks ago after the Consumer Price Index reading for October came in lower than expected, sending the stock market soaring.
The Nasdaq jumped 7.4% on Nov. 10, the day the report came out, while the Dow gained just 3.7%.
That response also indicates a decline in inflation and a shift in the Fed's interest rate policy would be likely to favor growth stocks over blue chips. Part of the reason why growth stocks, especially those in the tech sector, have underperformed this year is those companies are more sensitive to changes in the discount rate, which is used to value stocks. When interest rates rise, future earnings become less valuable, which explains why valuations in the tech sector fell so much in 2022. If interest rates fall or at least stabilize in 2023, which seems like a possibility as inflation is now moderating, tech stock prices should respond favorably.
Similarly, in 2009, the Nasdaq outperformed both the Dow and the S&P 500 in the rebound from the financial crisis.
Data by YCharts.
Big tech stocks look undervalued
Nearly all of the so-called FAANG stocks have fallen sharply year to date as the chart below shows, which also includes Microsoft and Tesla.
Data by YCharts.
Among this group, Apple and Microsoft have been the two best performers of 2022, but they're also in the Dow, so they influence both indexes.
The remaining five aren't Dow components, however, and their poor performances have weighed particularly heavily on the Nasdaq since it's a market cap-weighted index. The 30%-plus declines of Alphabet and Amazon have thus hit the index especially hard as both have market caps of around $1 trillion. And arguably, they look undervalued.
For example, Alphabet trades at a price-to-earnings ratio of 20, slightly below the S&P 500, even though its growth prospects seem more appealing than the average public company based on its track record and the secular growth trend in digital advertising. Amazon, meanwhile, is trading at its lowest price-to-sales ratio in eight years. It hasn't been this cheap on a revenue basis since before it started breaking out the numbers for Amazon Web Services as a stand-alone business segment. Currently, AWS is the source of all of Amazon's profits.
A similar argument can be made for Meta Platforms. While that company is in the midst of a large and risky bet on the metaverse, its core advertising business still generates tons of cash. Investors seem to have forgotten about that as the stock now trades at a price-to-earnings ratio of just 11.2.
Investors are likely to rotate out of safe blue chips
Many of the top-performing Dow Jones Industrial Average components in 2022 are safe blue chips like Coca-Cola, McDonald's, Walmart, UnitedHealth, and Johnson & Johnson, and all of those stocks have generated positive returns this year.
Data by YCharts.
However, the current valuations on many of these stocks look stretched, and part of the reason they've gained this year is investors have sought refuge in safe stocks. McDonald's, for example, trades at a price-to-earnings ratio of 34.3. Coca-Cola's ratio is 27.8, and Walmart trades at a ratio of nearly 50 as of this writing.
Those valuations, which are all higher than Alphabet's, reflect market sentiment, not a belief that those companies' earnings will outgrow the tech giant's long term.
Once it seems like the worst impacts of a recession are already priced into stocks, investors are likely to rotate out of these safe blue chips and back into tech holdings like the FAANG group and other growth-focused names.
When that happens, the Nasdaq is almost certain to outperform the Dow.
