According to seasonal tendencies in the U.S. stock market, large-cap stocks are expected to outperform small caps for the remainder of 2023.
This may come as disappointing news for small-cap investors, as large caps have been performing better for several months. For example, the large-cap-dominated S&P 500 (SPX) has gained 17.4% year-to-date, while the iShares Russell 2000 ETF (IWM) has gained 6.1% and the iShares Micro-Cap ETF (IWC) has lost 2.3%.
The underperformance of small caps is likely to continue for the coming months due to compensation incentives for institutional investors. These investors often receive a year-end bonus if they outperform the S&P 500. As the year comes to a close, these investors have a strong incentive to align their portfolios with the S&P 500, even if they believe that small-cap stocks are undervalued. This is because they want to avoid the risk of falling behind the S&P 500 in terms of year-to-date gains.
A study conducted in 2003 by Lucy Ackert, a professor of finance, and George Athanassakos, a professor of finance, found that this relationship between compensation incentives and the market persists. The study was updated two years ago and confirmed the same pattern.
“ Once January rolls around, institutional investors’ compensation incentives shift in the small-caps’ favor. ”
The professors’ theory does contain some good news for small-cap investors, provided they are patient: Once January rolls around, institutional investors’ compensation incentives shift in favor of small caps. This is when their appetite for risk is the highest throughout the year.
Historical stock market data supports this theory. Since 1926, small-cap relative strength tends to be the highest in January and declines steadily as the year progresses.
There are several ways to take advantage of large-cap relative strength in the stock market for the remainder of the year. One simple approach is to invest in an S&P 500 index fund, such as the SPDR S&P 500 ETF (SPY). Another strategy is to invest in SPY while simultaneously shorting an equal dollar amount of a small-cap fund, such as the iShares Micro-Cap ETF. This latter approach can be profitable even if the overall market declines, as long as small caps underperform large caps.
For those interested in investing in individual large-cap stocks, here are the 10 largest-cap stocks that are currently recommended for purchase by at least three investment newsletters:
| Stocks | Market Cap ($ 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 audited. He can be reached at mark@hulbertratings.com
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