The seasonal tendencies of the U.S. stock market during the remainder of the year indicate a preference for large-cap stocks over small caps.
This news might come as a disappointment to investors in small caps who have experienced underperformance in comparison to large caps for several months now. While the S&P 500, which is dominated by large-cap stocks, has gained an impressive 17.4% year-to-date, the iShares Russell 2000 ETF, representing small caps, has only achieved a 6.1% gain. In fact, the iShares Micro-Cap ETF has even lost 2.3%.
Unfortunately, the underperformance of small caps is expected to persist in the upcoming months due to the compensation incentives that institutional investors abide by. Many fund managers will receive a year-end bonus if they outperform the S&P 500 by the end of the year. As December 31 approaches, these managers have a compelling motivation to adjust their portfolios to mirror the S&P 500, ensuring positive year-to-date performance. Even if they believe that small-cap stocks currently offer good value, they will be inclined to avoid them to minimize the risk of falling behind the S&P 500.
The relationship between compensation incentives and market behavior was initially discovered in a 2003 study conducted by Lucy Ackert, a finance professor at Kennesaw State University, and George Athanassakos, a finance professor at the University of Western Ontario. Their research, published in the Journal of Business Finance & Accounting, revealed that this pattern persists even today.
However, it’s important to note that once January arrives, institutional investors’ compensation incentives shift in favor of small-cap stocks.
The Advantage of Small-Cap Investing in January
Investors who are willing to be patient can find good news in the professors’ theory about small-cap stocks. According to the theory, once January arrives, institutional investors’ compensation incentives shift in favor of small-caps. This is because their appetite for risk is at its peak during this time of the year.
To support this theory, historical data from the stock market aligns nicely. Since 1926, small-cap relative strength, which is highest in January, gradually declines as the year progresses.
Utilizing Large-Cap Strength in the Stock Market
If you prefer to lean on large-cap strength in the stock market until the end of the year, there are several strategies you can employ. One simple approach is to invest in an S&P 500 index fund like the SPDR S&P 500 ETF (SPY). This allows you to gain exposure to large-cap stocks without the need for individual stock selection.
Alternatively, you can bet on large-cap strength by investing in SPY while simultaneously shorting an equal dollar amount of a small-cap fund such as the iShares Micro-Cap ETF. This market-neutral strategy can still generate a profit even if the overall market experiences a decline, as long as small caps underperform large caps.
Recommended Large-Cap Stocks
For those who want to place individual stock bets, here are the top 10 largest-cap stocks currently recommended by at least three investment newsletters monitored by my auditing firm:
- Stock 1
- Stock 2
- Stock 3
- Stock 4
- Stock 5
- Stock 6
- Stock 7
- Stock 8
- Stock 9
- Stock 10
Investors who understand the dynamics of institutional compensation incentives and stock market trends can take advantage of the small-cap investment opportunity that arises in January. Whether through index funds or individual stock bets, there are various ways to align with the strength of large-cap stocks until the end of the year.
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