Large caps tend to outperform small caps as year's end approaches
There are seasonal reasons why you should favor large-cap stocks over small caps between now and the end of the year.
These seasonal factors are above and beyond the more widely known current reasons for why large caps are likely in coming months to beat the small caps. The other reasons include rising interest rates (a higher 10-year yield BX:TMUBMUSD10Y is correlated with lower relative returns for the small-cap sector) and heightened economic risk (ditto for increases in the Economic Policy Uncertainty index).
But even after controlling for higher interest rates and economic uncertainty, large-cap stocks tend to exhibit increasing relative strength as the end of the year approaches.
This seasonal tendency is plotted in the chart above. You will notice that, relative to the largest stocks, the smallest stocks tend to perform the best in January, and that their outperformance gradually declines as the year progresses and is negative in the fourth quarter. Notice also that the pattern is quite similar in the second half of the century-long sample, which increases our statistical confidence that this pattern of fourth-quarter large-cap relative strength is genuine.
The source of this pattern is the compensation incentives under which money managers operate, according to a 2003 study by Lucy Ackert, a professor of finance at Kennesaw State University, and George Athanassakos, a professor of finance at the University of Western Ontario. In their study, entitled "Institutional Investors, Analyst Following, and the January Anomaly," they found that those incentives lead managers to incur the above-average risk of small-cap stocks in January and to increasingly avoid them in favor of the large caps as the year's end approaches. The professors updated their study in 2023 and reached similar results.
It's not immediately obvious why compensation incentives would lead to large-cap relative strength late in the year, and those interested in a full explanation are encouraged to read the professors' studies. But, in a nutshell, it traces to the large number of managers who know they will receive a year-end bonus if they beat the S&P 500 SPX. If, as the fourth quarter nears, they are ahead of that benchmark for year-to-date return, they will have a powerful incentive to begin shifting their portfolios away from small caps and into the large caps that dominate the S&P 500 - thereby locking in their relative outperformance.
Professor Ackert, in an email, said that she expects "the pull of window dressing to be as strong as ever this year. ... Despite the economic uncertainty driven by the [Iran] war and inflation, the upward trajectory in [large-cap] valuations will likely continue through year-end."
The easiest way to exploit the pattern discovered by Ackert and her co-author is by buying an exchange-trade fund that focuses on the largest stocks. In addition to ETFs benchmarked to the S&P 500 (the largest of which is the State Street SPDR S&P 500 ETF Trust SPY) other possibilities include the iShares Russell Top 200 ETF IWL, which invests in the 200 largest-cap U.S. stocks.
If you're interested in investing in individual large-cap stocks, below is a list of stocks with at least $100 billion in market value that are both part of the S&P 500 index and which also are recommended by at least two of the investment newsletters whose returns are tracked by my performance-auditing firm. (They are listed in descending market-cap order.)
Ticker Stock # of newsletters recommending Market cap ($ billions)
NVDA Nvidia 2 $5,315
AAPL Apple 3 $4,622
GOOG Alphabet 2 $4,002
MSFT Microsoft 2 $3,626
AMZN Amazon.com 3 $2,698
AVGO Broadcom 2 $1,713
META Meta Platforms 2 $1,665
JPM JPMorgan Chase 2 $943
BAC Bank of America 2 $438
LRCX Lam Research 2 $378
MS Morgan Stanley 3 $338
GS Goldman Sachs 2 $300
TMO Thermo Fisher Scientific 2 $224
SCHW Charles Schwab 3 $184
ABT Abbott Laboratories 3 $182
DIS Walt Disney 3 $180
COP ConocoPhillips 2 $164
PFE Pfizer 2 $158
BMY Bristol Myers Squibb 2 $132
COF Capital One Financial 2 $129
CVS CVS Health 2 $122
LMT Lockheed Martin 2 $121
MDT Medtronic 2 $118
LOW Lowe's 2 $111
BNY Bank of New York Mellon 2 $110
CEG Constellation Energy 2 $103
ADBE Adobe 2 $100
Source: LSEG, Hulbert Ratings
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.
-Mark Hulbert