The top-down investment strategy is based on determining the health of the economy (and whether you want to even be investing at that time), the strength of different sectors, and picking the strongest stocks within those sectors to maximize returns. In this article, we will focus on the strength of the economy, the overall market and several tactics that can be used to determine this. For the purpose of this article we will assume the investor wants to hold investments over the long-term.
Start at the Top
The investment strategy is based on determining the strength of the overall market. This will help us determine on which side of the market we want to be: long, short or not in the stock market at all. We can use the following methods to determine this:
Is cash moving out of equities or into them?
If cash is leaving equities, it signals that prices will likely continue to head lower, or will soon start to head lower. Cash flowing into equities will lead to a rise in prices. Take an average of monthly figures published by the Investment Company Institute (ICI) to gauge whether cash is flowing into or out of mutual funds. Make a chart of this data so you can see what trends are occurring in the data. This is not a buy or sell signal on its own, but should be used in conjunction with other indicators.
Is money coming into and staying in the country, or is it leaving?
An increase in money flowing into the economy is bullish for stocks. If it is leaving, it is more likely the markets will head lower, as foreign investors continue to pull their money out of our economy and stocks. This information can be found at the Securities Industry and Financial Markets Association (SIFMA) or the Bureau of Economic Analysis (BEA).
After looking at the figures of money moving into or out of the economy and stocks, add the following step.
Based on a 10-year chart of the S&P 500 Index, are prices currently moving up or down over the last year or so?
In other words, is the chart showing progressively higher lows and highs (uptrend), or is it showing progressively lower lows and highs (downtrend)? The current trend is the where you want to take your positions.
You may also opt for using simple indicators, such as a 200-day moving average.
Look for a cross above the 200-day moving average. The cross is verified if money is flowing into the economy and stock market (via mutual funds) at an increasing rate. This confirmation will decrease the amount of breaks above the 200-day average, which are false.
For long positions, we want prices moving higher while money is flowing in to the stock market and the economy. If money is flowing in but the market is not moving higher, we should wait until all criteria are acting together. (In addition to technical analysis, you may be interested in learning about blending in fundamental analysis. Read Blending Technical And Fundamental Analysis for more.)
Add Cycle Analysis
While not required, we can add an additional element: cycles. Cycles can aid us in using the other information and determining whether we are nearing a market top. While fluctuations can occur and different research shows varying lengths of the cycles, they are still useful.
Look at an S&P 500 chart and pick out the point where prices made a top. Count the years (or months, for smaller time frame trades) between the tops, and then compare those numbers with where we currently are. For instance, if, on average, tops are three to four years apart, and it has been two years since the last market top, the cycles would indicate that we have at least another year (possibly two or a bit longer, on average) before we make another top. If our time frame is longer, we can simply look for longer-term cycles to use in our analysis.
We can also look at the length of time between one market bottom and the next. Patterns in time tend to repeat, and so they can be very useful in determining when the market is likely to peak or bottom. No rally is exactly the same as a previous one, but by looking at averages we can put the odds of timing more in our favor.
Putting It Together
Once we have an idea of the cycles and where we are within them, we want to look for opportunities where all of our signals line up. To buy investments, we want the market to have bottomed, have at least a year or longer left in the upward move (based on the cycle), the S&P 500 to be rising, and for cash to be moving into the country and also into equities.
This should give you a clear picture about where the market is headed over the next couple of years. This doesn't mean that the market will go in the direction we expect right away; it could take time, and there is the possibility that all indicators could reverse. The markets are dynamic, and can change direction very quickly. Thus, this method is not failsafe, since our analysis will not always be completely accurate. It is also important to remember that just because certain trends have begun is no guarantee that they will continue (resulting in losses, and not profits).
A good analysis of the market does not have to take a lot of time. We simply want to make sure that certain factors align, which will give us the best chance of placing ourselves on the right side of the market. And by using the factors mentioned, we greatly increase those chances. (Alternatively, learn about "bottom-up" investing, and how these two styles can be used together in Where Top Down Meets Bottoms Up.)