Top-Down Analysis: Finding The Right Stocks And Sectors

By Cory Mitchell AAA


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 then picking the strongest stocks within those sectors to maximize returns. In this article you will learn how to pinpoint the hottest sectors leading the market higher (or lower in a bear market) and how to find stocks within those sectors that will potentially maximize returns.

If your market analysis has determined that the market is in an uptrend and likely to continue for some time, you want to buy stocks that are showing the best potential to be big winners in the uptrend. Just because the market is moving higher does not mean that all stocks will perform well, and some will greatly outperform others. If we are in a bear market and the investor is not opposed to short selling, we can look for stocks that will likely perform the worst, therefore making a nice profit on the short positions as prices fall. For the remainder of this article we will only focus on uptrends, but the same principles apply to downtrends.

Pick the Right Sectors
If the market is moving higher, we can begin to look at different sectors to find which ones will provide us the greatest potential for profits. Certain sectors perform better than others, so if the market is heading higher, we want to buy stocks within sectors that are performing the best. In other words, we want to invest in sectors that are outperforming the overall market.

To find the hottest sectors, we will want to look at several time frames. Looking at two or three time frames will allow us to pick sectors that are not just performing well right now, but that have been showing strength over a longer time frame. The time frames looked at will vary from person to person depending on their overall time frame.

We only want to pick the sector that appears most often at or near the top of the list for top performing sectors. The top two or three sectors can be picked if some diversity is desired. It is within these sectors that we will be placing our investment dollars.

We can also view the charts of sector ETFs. The trend should be defined by a trend line, with the ETF showing strength as it rises off the trendline. But more importantly we want to narrow our focus to specific stocks. (Find out more about how ETF funds can assist your investing style in ETFs Smooth Road For Sector Rotation Strategies.)

Pick the Right Stocks
We could simply buy a basket of stocks reflecting the entire sector, and this could do reasonably well, but we can do better by just picking the best stocks within that sector. Just because a sector is moving higher does not mean that all stocks in that sector will be great performers, but a few will outperform; those are the ones we want in our portfolio.

One process for finding individual stocks is the same as the process for sector analysis. Within each sector, we want to find the stocks that are showing the greatest price appreciation. Once again, we can look at multiple timeframes to make sure the stock is moving well over time. The stocks that have performed the best over two or three timeframes are the stocks we will buy for our portfolio. Examine the charts of top performers by placing trending lines on the chart. The price trend should be defined and profit objectives based on chart patterns should indicate high gains relative to risk on the upside. (For a complete overview of other major strategies to compare to the technical top down approach, refer to our Stock-Picking Strategies Tutorial.)

It is important to note that there are some other factors to consider when buying a stock. Additional criteria to look at before you buy includes:

  • Liquidity: Buying stocks with little volume makes it hard to sell at a fair price if quick liquidation is required. Unless you are a seasoned investor/trader, invest in stocks that trade over a couple hundred thousand shares a day.
  • Price: Many investors shy away from high-priced stocks and gravitate towards low-priced stocks. Trade in stocks that are above $5, or preferably higher. This is not to say there are not "good" cheap stocks, or not "bad" expensive ones, but do not shy away from a stock just because it is a high price, or buy a stock just because it is cheap in dollar terms.

One additional note is that ETF trading has come a long way in recent years. If you do not want to hold multiple individual stocks, you may be able to find an ETF that will give you reasonably close results. There is no problem buying specific ETFs, if that is preferred, which can reasonably mirror what individual stocks would have been selected.

Exiting and Rotating
While going through this process cannot guarantee that you will make extraordinary returns, it does offer you a good chance to make better-than-market returns. Some monitoring of positions will be required to make sure your sectors and stocks are still in favor with the market. The investor must also be aware of overtrading, which can result in excessive commissions; this why we use multiple timeframes.

If your stocks or sectors begin to fall out of favor across the timeframes in which you were analyzing them, it is time to rotate into the sectors that are performing well. Your overall market analysis will also give you a guide of when you should exit positions. When major trend lines within the stocks being held, or sectors being watched, are broken, it is time to exit and look for new trade candidates. (Learn more about rotating sectors in our article Sector Rotation: The Essentials.)

Summary
This strategy does require some turnover of trades, as sectors and the leading stocks within those sectors will change over time. The object is to be in stocks that are leading the market higher in bull markets, and if you are not opposed to short selling, being short in the weakest stocks that are leading the market lower during bear markets. We do this by finding the hottest sectors (for a bull market) over a period of time and then finding the best performing stocks within that sector. By continually transferring assets into the best performing stocks we stand a good chance to make above average returns.

Also see Intermarket Analysis and Top-Down Technical Investing for more information on analyzing markets and stock selection.

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