What is Top-Down Analysis?
Top-down analysis looks at the "big picture" first for an investment idea or selection of stocks. After stocks have been identified as ideally placed to benefit from global trend, then the analyst will look into the actual details and balance sheets of this subset to make a final investment decision.
Understanding Top-Down Analysis
An investor who uses top-down analysis typically begins by analyzing the global economy. They then assess macro trends within economies that they believe have the best opportunities. Sectors that are poised to take advantage of those macro trends are then evaluated. Finally, individual stocks within favorable sectors are selected.
- Top-down analysis starts with the widest lens of analysis rather than starting with stocks.
- Top-down analysis usually involves a global analysis, a macro-trend analysis, sector analysis and then individual stock analysis.
- Top-down analysis is also used in technical analysis to refer to doing trend analysis on longer time frames before narrowing down to shorter time frame charts.
Elements of Top-Down Stock Analysis: Global Analysis
An investor subscribing to top-down analysis will usually start with a global analysis. Investors can assess the health of the global economy by analyzing the gross domestic product (GDP) of both developed and emerging markets. Investors should also consider a country’s geopolitical risks to ensure it is safe to invest. Strong GDP growth over several years is usually an indication that an economy is performing well. If an investors has a particular region in mind, then a global analysis may simply be used to narrow down between countries within that region.
For example, an investor looking at Asia may use a GDP and GDP growth filter to find countries in Asia with two years of growing GDP but a total GDP in the bottom 20 for the region in order to find emerging market stocks. Or an investor may simply look for the biggest Asian economy that is posting the strongest GDP growth - which in 2019 would be China.
Elements of Top-Down Stock Analysis: Macro Trend Analysis and Sector Analysis
The next common steps are the macro trend and sector analysis. Macro trends can be determined by looking at specific areas of a country’s economy that are showing strong signs of growth. Continuing the China example, the rising middle class in China has led it to become one of the world’s largest importers of food. To analyses macro trends further, investors could look at the specific foods that are getting imported, comparing staples like beef, pork, dairy, grain and oil seed products.
Once investors have identified promising macro trends, they can analyze sectors that are well positioned to take advantage. For example, after determining there is growing demand for beef and dairy foods in China, the investor would analyze the consumer goods sector, specifically the processed and packaged foods, meat products and farm products. An investor may choose to move early in the value chain, focusing on importers of commodity goods and even the companies abroad that feed into them. Alternatively, an investors can choose to move up the value chain and hone in on the domestic food processors who see the margins on turning commodities into products for the Chinese market. Margins and sector-level performance indicators can be used by an investor to judge where to continue digging.
Getting Down to the Stock Level in Top-Down Stock Analysis
After narrowing the search down to a particular sector in a given region, investors using top-down analysis finally get to look at specific stocks in the sub-sectors that have the most potential. In this example, the investor wants to find companies that will be ideally positioned to profit while meeting increasing demand for food products in China. A mix of fundamental and technical analysis can help decide what stocks to buy. For instance, Investors, might look for stocks in the meat consumer goods sub-sector that have a market capitalization over $1 billion and have recently crossed above their 200-day moving average. If there are multiple companies meeting this criteria, then fundamental analysis of their balance sheets can find the best within the group in terms of return on invested capital (ROIC) or some other measure.
Top-Down Analysis in Technical Analysis
Top-down analysis has a slightly different nuance in technical analysis. It is used to get a more comprehensive view of a security’s price action by moving from wider time frames to narrower ones. A day trader may first analyze daily or weekly charts to determine a security’s longer-term trend as well as its significant support and resistance levels, and then move to a smaller time frame to establish a good entry point. For example, if a security is trending higher on the daily chart, and there is bullish momentum on the hourly chart, a trader who is using top-down analysis could then move to a 15-minute chart and find a good entry point for her long position.