The seasonal trends in the US stock market between now and the end of the year will favor large-cap stocks over small-caps.
This must be particularly disappointing for the pressured investors in small caps, which have been underperforming the large caps for a number of months. In contrast to the 17.4% year-to-date gain of the large-cap dominated S&P 500 SPX,
For example, the iShares Russell 2000 ETF IWM ]has risen 6.1%, while the iShares Micro-Cap ETF IWC ]has lost 2.3%.
The underperformance of small caps is likely to continue for several months due to the compensation incentives with which institutional investors operate. Many managers will receive a year-end bonus if they end the year ahead of the S&P 500. So as December 31 approaches, they have a powerful incentive to make their portfolios increasingly resemble the S&P 500—and lock in a positive year. -better performance so far. These managers will be tempted to avoid small caps, even if they think these stocks represent good value at current prices, because the risk of their profits falling below the S&P 500 this year is too high.
This relationship between compensation incentives and the market was discovered in a 2003 study in the Journal of Corporate Finance and Accounting, by Lucy Ackert, professor of finance at Kennesaw State University, and George Athanassakos, professor of finance at the University of Western Ontario. Two years ago they updated their original research in the Journal of Risk and Financial Management and found that the pattern persists.
“ Once January arrives, institutional investors’ compensation incentives will shift in favor of small caps. ”
The professors’ theory contains good news for small-cap investors, provided they are patient: Once January arrives, institutional investors’ reward incentives shift in favor of small caps. Then their risk appetite is highest throughout the calendar year.
The accompanying diagram shows that the history of the stock markets fits in nicely with the professors’ theory. Since 1926, the relative strength of small caps, which is highest in January, has steadily declined as the year progresses.
There are several ways the stock market can lean on the relative strength of large caps between now and the end of the year. Perhaps the simplest would be to invest in an S&P 500 index fund, such as the SPDR S&P 500 ETF SPY.
A market-neutral way to bet on that strength would be to invest in SPY while shorting an equal dollar amount of a small-cap fund, such as the iShares Micro-Cap ETF. The latter approach would yield profits even if the market falls between now and the end of the year, as long as small caps fall more than large caps.
If you want to bet on individual large-cap stocks, below are the 10 largest-cap stocks currently recommended for purchase by at least three of the investment newsletters that my accounting firm monitors:
Shares | Market capitalization ($ billions) |
Apple Inc (AAPL) |
$2,858 |
Microsoft Corp (MSFT) |
$2,466 |
Alphabet Inc (GOOG) |
$1,652 |
JPMorgan Chase & Co (JPM) |
$1,101 |
Bank Amer Corp (BAC) |
$844 |
Morgan Stanley (MS) |
$470 |
Pfizer Inc (PFE) |
$217 |
Disney Walt Co (DIS) |
$198 |
CVS Health Corp (CVS) |
$150 |
Medtronic Plc (MDT) |
$124 |
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be reviewed. He can be reached at mark@hulbertratings.com
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