Why to Buy Large-Cap Stocks Now; Large-Cap Stocks Tend to Lead the Market Over the Last Several Weeks of the Year

Why to Buy Large-Cap Stocks Now

Large-Cap Stocks Tend to Lead the Market Over the Last Several Weeks of the Year

MARK HULBERT

Nov. 22, 2013 6:13 p.m. ET

Many investors are already familiar with the so-called January effect—the tendency for the stocks of the smallest companies to perform particularly well at the beginning of the year. Less well known, but equally pronounced, is another seasonal pattern, though this one occurs before the end of the year rather than after: Until Dec. 31, it’s the stocks with the largest capitalization that tend to lead the market. To exploit these tendencies, you should more heavily weight your equity portfolio toward large-cap stocks from now until the end of the year, at which point you would tilt toward small caps.Large-cap stocks are those of companies with the very biggest market capitalizations—currently $50 billion or more. Small-cap stocks are those at the opposite end of the spectrum, with market caps below $1 billion or so.

Consider the performance of large- and small-cap stocks in the U.S., based on data going back to 1926 from Dartmouth University professor Kenneth French and University of Chicago professor Eugene Fama, who recently was awarded the Nobel Prize in economics. During the last quarter of the year, on average, the 10% of stocks with the largest market caps outperform the 10% of smallest stocks by 3.0 percentage points.

In the first quarter of the year, by contrast, the small-caps beat the largest-cap stocks by an average of 8.8 percentage points.

The source of these seasonal tendencies is institutional managers’ shifting appetites for risk during the year, according to research conducted by Lucy Ackert, a finance professor at Kennesaw State University in Atlanta. In an interview, she said those managers’ willingness to invest in risky stocks will be at its highest in January, and that this in turn leads them to favor small-cap stocks over large caps.

The average small-cap stock will therefore lead the market, while the typical large cap will lag.

Institutional managers’ risk appetite declines gradually through the year, and by the end of the year it is the reverse of what it is at the beginning. Now the typical institutional manager will be more conservative than at any other time of the year, leading him to shun small caps in favor of large-cap stocks. That makes it large caps’ turn to lead, with small caps lagging.

Why would managers have more appetite for risk at the beginning of the year than at the end? One big reason, according to George Athanassakos, a finance professor at the Ivey Business School of Western University in Ontario, can be traced to the compensation incentives under which many managers operate.

In an interview, he referred to a number of academic studies, including one that he co-wrote with Ms. Ackert. Those studies found that those incentives, on average, lead many managers as year-end approaches to make their portfolios look more like the benchmarks against which they will be judged when their year-end bonuses are determined.

More often than not, those benchmarks are dominated by large-cap stocks.

These incentives will be especially strong for managers who are ahead of their benchmarks as they approach the end of the year, Mr. Athanassakos says. By making their portfolios look like their benchmarks, they lock in their superior return and “thereby secure their bonus,” he says.

There are similar incentives to reorient portfolios toward larger-cap companies for managers who trail their benchmarks as year-end approaches—though for different reasons, according to Ms. Ackert. Their motivation will be to avoid “having to reveal in their year-end reports that they own a terrible-performing stock that most investors have never heard of,” she says.

Once January arrives, however, all managers’ compensation slates will be wiped clean, says Mr. Athanassakos. That’s when the average manager will make the calculation that, to “maximize the probability of getting my bonus at the end of the year, I have to take on more risk,” as he puts it.

You don’t have to be a short-term trader to exploit these tendencies. Longer-term investors can take advantage of them by timing their purchases and sales in the coming weeks. If you were already planning to sell some large-cap stocks you currently own, for example, history suggests you will get a better price by doing so at the end of December.

One option for those interested in a short-term trade to exploit large-cap strength over the next five weeks is to invest in exchange-traded funds that are benchmarked to specific sectors. The Guggenheim Russell Top 50 Mega Cap XLG +0.42% ETF invests in the 50 U.S. companies with the largest market caps; it has an expense ratio of 0.20%, or $20 per $10,000 invested. The market cap of the median stock it owns is $125 billion.

If you’re interested in betting on individual stocks, you might consider the large caps that currently are most popular among those Hulbert Financial Digest-monitored advisers who have beaten the stock market, as measured by the Wilshire 5000 index, over the past 15 years. In addition to pharmaceutical companies Pfizer PFE +0.47% and Johnson & Johnson, JNJ +0.75% this list includes tech giant Apple AAPL -0.26% and oil majorChevron. CVX +0.46%

Your approach to small-cap stocks will be different, since you will want to wait until near the end of the year to invest in them. Given small-cap stocks’ high volatility, it’s also especially important not to put all your eggs in one basket.

The best way to exploit the group’s anticipated strength might therefore be to invest in an ETF that is benchmarked to the entire sector. One of the best known is the iShares Russell 2000 IWM +0.49% ETF, which has a 0.24% expense ratio. The market cap of the median stock it owns is $594 million.

If you’re nevertheless looking for some small-cap stocks to add to your portfolio at year-end, here are three with market caps below $1 billion that are also popular among the 15-year market beaters on the Hulbert Financial Digest’s list: retailer Big 5 Sporting GoodsBGFV -0.05% ; telecommunications firm 8×8 EGHT +1.17% ; and gun maker Smith & Wesson Holding. SWHC +1.10%