Fund managers' compensation incentives play a big role in large caps' end-of-year relative strength.

Now is a good time for investors to overweight large-cap stocks and underweight small caps. That's because large caps historically have outperformed small caps as the end of the year approaches.

This tendency is illustrated in the chart below, which plots the average monthly amount by which small-cap stocks outperform large caps. Relative to the largest stocks, the small caps tend to perform best in January. This outperformance gradually declines as the year progresses.

The chart also shows that the pattern persists in the second half of the sample (since 1970). This indicates the pattern is not a fluke of just a couple of years. The tendency for the relative strength of small caps to be weakest in the fourth quarter is significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.

Why large caps outperform late in the year

As I've often argued, you shouldn't bet on a pattern - no matter how statistically significant - unless there is a good theoretical explanation for why it should exist. One explanation comes in a 2003 article in the Journal of Business Finance & Accounting. A 2021 update of that study in the Journal of Risk and Financial Management reported that the pattern continued to exist.

The study traces late-year large-cap relative strength to bonuses that fund managers receive at year's end if they outperform the S&P 500 SPX. That means managers who are ahead of the S&P 500 have an incentive to lock in their lead by gradually turning their portfolios into a closet index fund until Dec. 31. In the coming weeks, they will likely be looking to sell their small caps and buy the large-cap stocks that dominate the S&P 500.

The corollary of this theory is that fund managers' willingness to deviate from the S&P 500 will be greatest in January. Sure enough, that's when riskier small caps have exhibited their greatest relative strength over the large caps. To be sure, correlation is not causation. But the professors ran several tests to eliminate other possible explanations, which increased their confidence that compensation incentives play a role in why large caps saw end-of-year relative strength.

Large-caps' relative strength this year may kick in a few weeks later than in prior years.

Lucy Ackert, a professor of finance at Kennesaw State University and co-author of the study, added in an interview that while she is not aware of any reason to expect this pattern being weaker in coming years, large-caps' relative strength this year may kick in a few weeks later than in prior years. That's because small-cap stocks especially benefit from lower interest rates and investors may bid these stocks up in the wake of the Federal Reserve's meeting next week, when the central bank is expected to cut interest rates.

With that in mind, I constructed a list of large-cap stocks that are recommended by at least two of the investment newsletters tracked by my performance-auditing firm. I narrowed the list to include only those whose market caps exceed $100 billion.

The 18 stocks that survived this winnowing process are listed below in descending order of recent market valuation. Most are well-known, including Apple Inc. $(AAPL)$, Exxon Mobil Corp. (XOM), Johnson & Johnson $(JNJ)$, Walt Disney Co. $(DIS)$, Charles Schwab Corp. $(SCHW)$ and $Capital One Financial Corp(COF-N)$. $(COF)$.