Why you should favor large-cap and mega-cap stocks

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Favor large- and mega-cap stocks. These market segments have held up better than their small- and mid-cap counterparts in the last few weeks, providing a bit of cushion from the volatility. And with the recent sell-off having made them more attractively valued, I suggest investors continue to emphasize larger capitalizations, particularly with more volatility likely on the horizon.

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Market Realist – The graph above shows the total year-to-date returns from the S&P 500, which tracks large cap equities (SPY), the S&P 400 which tracks mid-cap equities (MDY), and the S&P 600, which tracks small-cap equities (IWM). Large-cap equities have been able to hold their value better than small-cap and mid-cap equities.

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Market Realist – The sell-off has made large caps cheaper and therefore more attractive. The positive earnings report streaming in for the third quarter shows that out of the 82 companies on the S&P 500 reporting earnings up to October 17, 2014, 68% exhibited a positive earnings surprise (data from FactSet). The graph above shows the sector’s positive earnings surprises. The strong earnings reports and price declines are making large-cap stocks look attractive.

Small-cap stocks tend to be susceptible to a change in interest rates or an uptick in volatility (VXX). Small-cap stocks also entered the year highly overvalued. The negative earnings outlook for small caps has increased valuations despite the declining prices we’ve seen during the year.

Markets are likely to continue to exhibit higher levels of volatility in the future. With increased geopolitical worries, including the Ukraine-Russia conflict, terrorism threats, unrest in Syria and the Middle East, mounting worries of a recession in Europe (EZU), and rising anxiety about Ebola, volatility is likely to be a key trend going ahead. Investors should stick to relative valuation, keep their portfolios diversified by investing in global equities (QWLD), and favor large-cap and mega-cap stocks in the current context.

Read our series 5 things for every investor’s to-do list as 2014 draws to a close to learn more about how you can bolster your portfolio.

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