Key Points
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The Nasdaq has sold off in the last month while the Dow has gained.
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The Dow is more tech-heavy than it used to be.
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The Nasdaq is better positioned to maximize earnings growth over the long term than the Dow.
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In the first market session following the midterm elections, the Dow Jones Industrial Average (DJINDICES: ^DJI) gained 3% — well ahead of the S&P 500 (SNPINDEX: ^GSPC) and Nasdaq Composite (NASDAQINDEX: ^IXIC). As of market close on Nov. 4, the Dow is up 11% year-to-date (YTD) — ahead of the Nasdaq Composite’s 10.7% gain. Which is a stark contrast from where the indexes were just one month ago, when the Nasdaq was outperforming the Dow by more than ten percentage points.
Here’s why the Dow is outpacing the Nasdaq and where the indexes could be headed from here.
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Updating the AI stock narrative
Democrats retaking the House and Senate could lead to stricter artificial intelligence (AI) regulation that could slow the AI data center build-out. But the Nasdaq was already in a steep drawdown leading up to midterms. Higher interest rates make borrowing capital to fund AI spending more expensive. A sell-off in the semiconductor industry, paired with brutal drawdowns in major stocks like Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), was weighing on the index.
Investors have grown increasingly concerned with capital expenditures (capex) going toward AI — especially from companies like Alphabet, Amazon (NASDAQ: AMZN), and Meta Platforms that have turned free cash flow (FCF) negative. A lot of that capex is funneling toward technology infrastructure, networking equipment, custom AI chips, and other long-term data center costs.
For the AI build-out to be sustainable, spending has to show a return on investment for the cloud giants and frontier models such as OpenAI’s ChatGPT and Anthropic’s Claude. Anthropic could go public as soon as mid-November. Anthropic will face far more scrutiny under the public markets’ microscope than it did as a private company. And if investors view its compute spending as excessive, that could add further doubt to the broader AI investment thesis — which affects the Nasdaq Composite much more than the S&P 500 or the Dow.
Amazon, Nvidia, and Alphabet make the Dow more growth-oriented
Given its higher weighting in value stocks and blue-chip dividend stocks, the Dow tends to hold up better than the Nasdaq during times of uncertainty or tech-driven sell-offs. However, investors should be aware that comparing today’s Dow to past versions of the index can be misleading.
The Dow has just 30 components compared to thousands in the Nasdaq Composite. Since 2020, the Dow has added Salesforce, Honeywell Technologies, Amgen, Amazon, Nvidia, Sherwin-Williams, and Alphabet – replacing ExxonMobil, RTX, Pfizer, Walgreens Boots Alliance, Intel, Dow, and Verizon Communications. So the Dow isn’t as value- or industrial-driven as it used to be. It’s still less tech-heavy than the Nasdaq, but it’s also more of a growth index too.
The Dow is also price-weighted, meaning that the companies with the highest stock prices, rather than those with the highest market cap, carry the most weight. In the Nasdaq, Apple, Nvidia, and Microsoft are the most heavily weighted components because they have the largest market caps. Those three stocks are also in the Dow, but all are weighted less than Goldman Sachs because of its high stock price and lack of stock splits since going public in 1999. This weighting structure further complicates the Dow’s moves.
The Nasdaq is up more than 5x over the last decade
The last time the Dow outperformed the Nasdaq was in 2022, when the Nasdaq plunged 33.1%, and the Dow fell 8.8%.
Including that brutal decline, you would have still been better off buying the Nasdaq on Jan. 1, 2022 than the Dow, as the Nasdaq is up 68% since then compared to 56% for the Dow — even when factoring in dividends.
History says that the six months following midterm elections tend to be a seasonally excellent period for the stock market. And over the long term, trading in and out of stocks and sectors based on political outcomes is a grave mistake.
A far better approach is to build your portfolio around fundamentally sound companies with a runway for future earnings growth. Despite being more volatile than the Dow, the Nasdaq has produced superior gains over the last three-, five-, 10-, and 20-year periods because the earnings growth rates of major Nasdaq companies have been impeccable.
While AI capex is definitely a strain on FCF for hyperscalers, it’s a mistake to overlook the operational efficiency of top Nasdaq stocks. According to data from Yardeni Research, analyst estimates for the S&P 500 annual operating margin are in the mid- to high-teens. Meanwhile, Apple is converting 33 cents of every dollar in trailing 12-month revenue into operating income. Alphabet, Microsoft, Broadcom, and Nvidia are even better. Amazon achieved a 13.9% operating margin in its latest quarter — an all-time high for the company. But its operating margin is dragged down by its retail business. In Amazon’s latest quarter, Amazon Web Services had an operating margin of 38.7%.
Quality growth stocks win in the long term
Safe sectors like consumer staples and healthcare can rally during periods of uncertainty due to their recession-resistant nature. These sectors can be excellent for risk-averse investors, those focused on capital preservation over appreciation, or income investors looking to supplement income in retirement. But tech-focused companies will likely continue to outperform the Dow over the long term because they have more opportunities to invest in high-potential ideas that offset the ideas that don’t work out. A consumer staple like Coca-Cola developing or acquiring another beverage brand has a far different risk and potential reward profile than paradigm-shifting technologies that fundamentally change businesses and everyday life.
Investors should continue to scrutinize AI capex spending. But the cash burn won’t continue forever. If AI investments begin showing returns for hyperscalers and, downstream, for software companies, it will create a ripple effect through the Nasdaq and, in turn, justify more spending on compute and AI infrastructure.
With midterms in the rearview, now is a good time for investors to conduct a portfolio review to ensure they have high conviction in the Nasdaq stocks they do own. Volatility is simply the price of admission for the tech-heavy Nasdaq. But over the long term, high-quality growth stocks will likely continue rewarding patient investors far more than safe stocks.
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Daniel Foelber has positions in Broadcom and Nvidia. The Motley Fool has positions in and recommends Alphabet, Amazon, Amgen, Apple, Broadcom, Goldman Sachs Group, Honeywell Technologies, Intel, Meta Platforms, Microsoft, Nvidia, Pfizer, RTX, and Salesforce. The Motley Fool recommends Sherwin-Williams and Verizon Communications. The Motley Fool has a disclosure policy.
