Do FAANG Stocks Predict Dow Jones Industrial Average (DJIA)?

-- Intended for New College Graduates --

(Click on any image to enlarge)

John, a new college graduate with co-concentrations (Econ and Math) is interviewing for Equity Analyst with a major Hedge Fund. 

Interviewer: Thanks for interviewing with us, John. On that corner laptop you'll find a spreadsheet containing one year of daily closing prices - between 7/1/2018 and 6/30/2019 - pertaining to the Dow Jones Industrial Average (DJIA) and FAANG (Facebook, Amazon, Apple, Netflix and Google) stocks. Please analyze the data and give us your conclusions as to:

a) The FAANG stock that is most predictive of the DJIA so, from time to time, we could recommend it to our clients in place of the Dow ETF.

b) The FAANG stock that best represents as a hedge to the DJIA so it could be recommended as the DJIA becomes over-valued.

c) Finally, the FAANG stock that is highly predictive of the DJIA but has low multi-collinearity within the mix.

Once you are ready, just press 201 on this dial and I'll be back to talk to you.

___________________________________________________

As the interviewer returns, John presents his conclusions:

1. John -- The above correlation matrix clearly demonstrates that Amazon (AMZN) is the FAANG stock that is most predictive of the DJIA. The regression output, with DJIA as the dependent variable in the equation, further confirms it via its smallest standard error.

Interviewer -- But Netflix (NFLX) has better t-stat and lower p-value? Doesn't it contradict your conclusion?

John -- No. The correlation coefficient, which is the primary metric here, makes Amazon a far better (DJIA) predictive choice than Netflix.

2. John -- Of the FAANG components, Facebook (FB) is best hedge as it has the lowest correlation with DJIA. The regression out also confirms it via its negative coefficient.

Interviewer -- Would it be okay to recommend Facebook as a DJIA hedge to our clients?

John -- If the choice is limited to the FAANG complex only, yes. But there are other ETFs with much lower correlations with DJIA. I'd rather research and recommend one from the outside universe.     

3. John -- Apple (AAPL) is the FAANG stock that is highly predictive of the DJIA, but has lower multi-collinearity with the other components. The graph shows how Apple diverges from Facebook (which is the inside hedge component) with very low r-squared.

Interviewer -- Would you play the FAANG complex? If so, how?

John -- Each component has its own contributory properties so the complex as a whole makes a good investment vehicle. I would play it via a liquid FAANG ETF and as the DJIA becomes over-valued I would introduce an ETF with good hedging property.

   

Disclaimer - The author is not advocating the stocks/indices listed here. Consult your Registered Rep, RIA or Financial Planner for an appropriate asset allocation model and the suitability of stocks, indices and other holdings for your portfolio.


Good Luck!

Sid Som, MBA, MIM
President, Homequant, Inc.
homequant@gmail.com