By Mark Hulbert
Institutional investors who dominate the stock market increasingly favor large-cap stocks as the end of year approaches — and therefore you should too.
The reason for their year-end large-cap bias traces to the compensation incentives under which they operate.
Many managers know they will receive a year-end bonus if they finish the year ahead of the S&P 500 /zigman2/quotes/210599714/realtime SPX -1.79% . So if around this time of year they are ahead of that benchmark, they have a powerful incentive to start making their portfolios look increasingly like an S&P 500 index fund, thereby locking in their positive “alpha.”
Since the S&P 500 is a cap-weighted index dominated by a couple dozen of the largest-cap stocks — including Apple /zigman2/quotes/202934861/composite AAPL -0.80% , Microsoft /zigman2/quotes/207732364/composite MSFT -1.89% /zigman2/quotes/207732364/composite MSFT -1.89% and Alphabet /zigman2/quotes/205453964/composite GOOG -0.95% /zigman2/quotes/202490156/lastsale GOOGL -0.96% — this means fund managers will more heavily weight those stocks and underweight small-cap stocks outside the index.
Even managers who in September are slightly behind the S&P 500 will be tempted to become what’s known as closet indexers as the end of year approaches, according to researchers.
To be sure, by doing that, managers lock in their negative alpha. But they also avoid investing in stocks that will lag the S&P 500 by such huge amounts that they run the risk of being demoted or even fired.
According to this theory, it is at the beginning of the year that institutional investors will be most willing to invest in the small-cap stocks that are outside of the S&P 500. So, if this theory is an accurate description of Wall Street behavior, we should see the greatest small-cap relative strength in January, along with a gradual shift through the year toward large-cap relative strength near the end of the year.
The research supporting this theory was first published in 2003 in the Journal of Business Finance & Accounting , by Lucy Ackert, a professor of finance at Kennesaw State University, and George Athanassakos, a professor of finance at the University of Western Ontario. Last year they published an updated analysis in the Journal of Risk and Financial Management , and found that the pattern persists.
It’s noteworthy that a pattern continues even after its existence has been widely publicized. Patterns typically disappear almost as soon as they are discovered, as arbitrageurs eagerly exploit the trend and thereby kill the goose that lays the golden egg. That this didn’t happen in this case suggests that its underlying causes are strong enough to withstand such goose-killing behavior. That, in turn, suggests it continues to be a good bet to persist into the future.
A graphic illustration of the pattern appears in the accompanying chart, below. It is based on data back to 1926, and reports the average amount by which small-caps outperform large-caps at different points throughout the year. Sure enough, small-cap relative strength is strongest in January and becomes progressively smaller as the year progresses — and is significantly negative in the last quarter of the year.
Not every year lives up to these historical averages, but last year certainly did. Consider the performance of the large-cap stocks I highlighted in this space in mid-September 2021. From then until the end of that year, they produced an average gain of 5.5%. The Russell 2000 Index /zigman2/quotes/210598147/delayed RUT -2.78% , a widely used benchmark for the small- and mid-cap sectors, gained just 1.0% over the same period, and the Russell Micro-Cap Index of even smaller-cap stocks lost 3.9%.
If you’re tempted to bet on a repeat of this pattern for the rest of 2022, your simplest option is to invest in an S&P 500 index fund /zigman2/quotes/209901640/composite SPY -1.80% /zigman2/quotes/201209218/composite VOO -1.78% . But if you want to make individual large-cap bets, the table below lists the 20 largest-cap stocks within the S&P 500 that are also recommended by two or more of the top-performing newsletters monitored by the Hulbert Financial Digest. The table of large-cap stocks I presented a year ago was constructed in the same way.
|Stock||Market cap ranking in S&P 500||Number of newsletters recommending|
|Apple /zigman2/quotes/202934861/composite AAPL||1||4|
|Microsoft /zigman2/quotes/207732364/composite MSFT||2||3|
|Alphabet /zigman2/quotes/205453964/composite GOOG /zigman2/quotes/202490156/lastsale GOOGL||3||4|
|Amazon.com /zigman2/quotes/210331248/composite AMZN||4||2|
|Berkshire Hathaway /zigman2/quotes/200060694/composite BRK.B||6||3|
|Johnson & Johnson /zigman2/quotes/201724570/composite JNJ||8||2|
|Meta Platforms /zigman2/quotes/205064656/composite META||9||2|
|JPMorgan Chase /zigman2/quotes/205971034/composite JPM||14||3|
|Procter & Gamble /zigman2/quotes/202894679/composite PG||15||2|
|Home Depot /zigman2/quotes/208081807/composite HD||17||2|
|Bank of America /zigman2/quotes/200894270/composite BAC||20||2|
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 email@example.com .