Chapter 9 Top Down Analysis Success Demands Singleness of Purpose Armed with a little knowledge about the stock and options market as well as a desire to trade, many new traders are faced with the daunting task of finding specific opportunities in the broad stock market. Think for a moment how difficult of a task that this truly is. For experienced investors, they ve seen various market cycles, moods, conditions, etc. Chances are that they have encountered a market structure in the past that is similar to what they are faced with today, and can quickly decide where the appetite for risk will grow next. For a novice trader, they just want to find something that is mildly predictable, but even that can serve as a tough task day-to-day. Rather than try to condition you to try and predict things that you ve yet to experience, we ll discuss in this section how to determine what mood the market is in, and how to know what investors are investing in, above all else, at any given point. This will help to increase your probability of success in taking a position. One approach to finding a suitable investment is referred to as top-down analysis. In a top down approach to analyzing the market, the trader gets familiar with broad market trends then moves into sector and industry analysis to determine what stock to buy. The reverse method of this analysis is referred to as bottom-up analysis which simply means you look for stock to trade then inspect its industry and sector, and then finishing with a look at the market. There is no right or wrong way to analyze the market, but the main benefit from a top-down approach is to inspect the market first, then find out what industries or groups are outperforming or thriving. Then it becomes a matter of picking the best company that represents this trend. The goal for a successful trader is not to become an economist, industry analyst, or even an expert for a particular stock. Instead, a successful trader should have his finger on the pulse of the market. A trader should know what type of mood the market is in, and should know what its appetite for risk is. This is always evident based on day-to-day fluctuations in particular stocks and sectors of the market. A trader can also opt to better acquaint themselves with fundamental analysis, learning the broad economic trends that drive the market. This might help knowing from a general perspective where prices are likely to move, however, studies have shown very little day-to-day correlation with the economy and the direction of price movements. However, by being better acquainted with the fundamentals that drive the price of a stock, or influence the direction of the market, the trader is better equipped to make accurate assumptions about how long these underlying trends will last and how this will translate into potential trading opportunities. The First Step in a Top-Down Approach: Broad Index Analysis A true top-down analysis will start at the top of the market; the broad market indices. The S&P 500, the NASDAQ composite, the Dow Jones, and the Russell 2000 are going to cover most segments of the broad market. The S&P is a broad look at 500 individual stocks. The NASDAQ composite is geared more towards technology based companies. The Dow Jones is an index of 30 blue chip stocks, while the Russell 200o index covers an index based on 2000 small cap companies. By tracking these four indices, you ll get a broad perspective on different areas of the market, as well as a look at conservative and aggressive stock indices. The first step in analyzing the broad market indices is to pull them up on a chart. You can do this individually, or simultaneously; whichever you prefer. Below is a snapshot of a grid chart of the four indices. Top Down Analysis Page 1
Figure 1: A Grid Chart of the Broad Market Indices When you think about the contents behind each index, you ll find that the more conservative indices are the Dow and S&P 500. These indices track big cap companies, blue chips, and well established companies such as Microsoft (MSFT), General Electric (GE), Home Depot (HD), etc. The more aggressive indices would be the NASDAQ and Russell 2000. Tech stocks and Small Cap stocks are instruments that are much more volatile than most stocks, and can generate great returns, but also come with a high level of risk. The reason you want to know this is because day-to-day you might notice one index performing much better than the others. Or perhaps you ll find that one index is really lagging behind the others. This is a great way to determine the market s appetite for risk. Looking at the image above, to the left side of each of the four charts above, you ll notice the Dow and S&P 500 trading in a month long range, while the NASDAQ and Russell are in a downtrend. This would indicate that the market is selling off riskier assets, and holding on to more conservative holdings. When markets diverge like this, it is usually sign that the markets are getting ready to correct, as you see in the months going forward. Top Down Analysis Page 2
Figure 2: Divergences in Equity Indices The direction of the market is always important, but as you ll learn in upcoming chapters, what the market is buying is as important, if not more important to know. If the markets are heading higher, but risky assets are lagging, it means that investors are not as convinced in the market. If markets are correcting, but risk assets are outperforming, then it means traders are positioning for a big move to the upside. As you review the broad market indices, here are a few questions you ll want to ask yourself when reviewing these charts. What is the direction of the trend? Many traders will ask this question on multiple time frames. Looking at the charts above, the overall direction has been slowly moving lower, but in the last few weeks, markets have been up strong. It is important to remember, a trend is a compilation of highs and lows. The collective movement of these highs and lows will either be heading higher (higher highs, higher lows), or will be heading lower (lower highs, lower lows). Looking at the indices above, each high and each low is progressively lower than it s prior. Is the most recent move overbought or oversold? Many traders will use various technical indicators, like oscillators to help determine if prices are overbought or oversold. This can be determined by using a RSI, MACD, Stochastic, etc. If you have an indicator in overbought territory, and you are looking to initiate a long position, the overbought reading should make you reconsider the timing of a long entry. The inverse is true for a short position. Remember, success is found in anticipation. It is hard to find success in being late to a price swing. Are there any divergences? This is an important step to consider and is one that many traders neglect to answer. However, these divergences are very effective in predicting future movement, as they depict exactly what the markets appetite for risk is, or lack thereof. The divergences pointed out in Figure 2 were a great signal to a market that was losing strength quickly. This is a great confirmation tool to point out the underlying strength or weakness in stocks. Top Down Analysis Page 3
Which index is outperforming? The index that continues to outperform helps you understand where you are in the market sentiment cycle. In the early stages of a rally, where investors lack confidence, they will gravitate towards less risky, more conservative investments. As the trend continues and the market has established a trend, investor confidence rises. This is when they are more likely to take on additional risk. This is where they take profits on low beta stocks, and pursue stocks that generate higher returns, such as technology or small cap stocks. The relative outperformance is a great measure to take into consideration day-to-day. This helps to solidify the market mood and risk appetite. Where is the market headed in the short term? Through a sound technical analysis, this is the final question that one should ask and be able to answer. As an example, if you are an investor looking to buy a few stocks, but the market has established a downtrend and you ve just missed a big rally chances are that the timing of your stock purchases would be better if postponed. Make sure that the short term market forecast is conducive to the strategy you are looking to perform. Activity: Identify the Current Market Trend and Conditions Take a moment to perform this task on your own. Review the four indices discussed and try to come to a conclusion for the short term bullish or bearish? The Second Step in a Top-Down Approach: Sector Analysis For this task, you ll want to start in a similar fashion as we ve outlined for broad index analysis. You ll want to start with the 9 principal sectors of the S&P 500. They are: Financials Industrials Energy Basic Materials Technology Consumer Discretionary Consumer Staples Healthcare Utilities A great way to track each sector is through the use of sector tracking ETFs. These ETFs mirror the performance of each sector and trade just like a stock. Below is a list of each sector, and its corresponding tracking ETF. Financials.SPDR Select Sector Fund Financial (XLF) Industrials SPDR Select Sector Fund Industrial (XLI) Energy SPDR Select Sector Fund Energy (XLE) Basic Materials.SPDR Select Sector Fund Materials (XLB) Technology.SPDR Select Sector Fund Technology (XLK) Consumer Discretionary..SPDR Select Sector Fund Consumer Discretionary (XLY) Consumer Staples..SPDR Select Sector Fund Consumer Staples (XLP) Top Down Analysis Page 4
Healthcare SPDR Select Sector Fund Health Care (XLV) Utilities SPDR Select Sector Fund Utilities (XLU) Consider creating a watchlist of these ETFs. This will help you check in on them daily to see how they performed, and more importantly, how they performed against each other. Below is a portfolio watchlist from Finviz (www.finviz.com). Here you can see thumbnail charts of all 9 sectors simultaneously. Figure 3: Thumbnail Charts of the Sector Tracking ETFs via Finviz Each sector carries its own risk level, beta, and individual characteristics. As an example, financials, technology and basic materials are high beta. They tend to move more than the other sectors and have a higher level of volatility than the others. The consumer staples, utilities and healthcare sectors are defensive in nature, and are generally very low beta. This means that they are not very volatile, and will hold up better than other sectors when the market is weak. You can tell a lot about what the market is anticipating by the way the sectors perform day-to-day. For example, if the market is in an uptrend, and you start to notice that the XLU, XLV and XLP are performing better than the other sectors, it tells you that money is rotating into defensive assets. This means the market is moving money away from risk assets, and putting into defensive investments. This usually happens when smart money is expecting a market correction. Aside from the overall analysis, part of your objective here is to determine which sectors are performing better than others. Looking at the charts above in Figure 3, simply look at where prices are today, relative to their respective charts, and in comparison with other sectors. For example, the Industrials sector (XLI) and Consumer Discretionary sector (XLY) are trading at or near their recent highs. A look at the other sectors shows that all other sectors are closer to their recent lows as opposed to highs. You ll want to pick one or two sectors to shop through as we move into the next step, which is picking a stock. In this example, we ll focus on the Industrials sector and walk through the steps of how to select a stock. The Third Step in a Top-Down Approach: Industry Group Analysis In each sector, there will be a long list of industry groups. Industrials is a broad label. There are hundreds of companies that trade within the Industrials sector. Each sector is broken down into industry groups. This will help you get more specific when Top Down Analysis Page 5
classifying a stock. The image below illustrates how you can use Finviz to break a sector down to see the different industry groups that exist within the sector. Figure 4: Using the Finviz Screener for an Industry Group Analysis Initially, it can take some time before you become familiar with how this all works. To hedge the learning curve, you might opt to take the top 2-3 stocks from each group, and put them into a watchlist labeled industrials. You can do the same for each sector. You ll find in going through an industry group that there are many companies listed, but not all are good investment vehicles. In fact, you can eliminate most of them based on price, liquidity, and lack of fundamentals. Let s assume you select the Residential Construction group from the Industrials sector. Assume you ve read lots about the housing recovery, and have seen a few charts of the housing stocks come across your searches recently. The group contains 17 listed stocks, and you ll need to narrow that list to a smaller number. In the screener, select the drop down menu for the average volume search criteria and select Over 1 M. This will only list the stocks that trade over a million shares on average, which narrows the list down to 10. The final step in our top-down analysis is picking out a stock from our list. The Fourth Step in a Top-Down Approach: Picking a Stock Once you ve analyzed the market, picked out a strong sector, and narrowed the field down to a particular industry group, the final step is picking a stock. Since we ve narrowed our industry group to 10 stocks, let s take these charts and give them a visual inspection. Below is a snapshot of the 10 stocks listed in the Residential Construction industry group with over 1 million shares traded on average. Top Down Analysis Page 6
Figure 5: Thumbnail Charts of the Residential Construction Group via Finviz If the residential construction stocks have been trading well as of late, you ll see clear leaders in the list above, as well as clear laggards. Stocks near their highs, such as HOV, LEN, PHM and RYL have been leading the group higher, while stocks like BZH, DHI, GFA and TOL are lagging significantly behind their peers. If you are looking to initiate a long position, focus on strength. This is also a time where you might take into consideration individual characteristics that you prefer in stocks that you trade. For example, you might opt to trade stocks that are more volatile than their peers. You might opt for stocks that trade options. You might only trade stocks with certain fundamental data points. If you have preferences, use them to narrow the field to a more manageable list. Using the same methods of technical analysis performed on the market, sector, and industry group, you ll want to apply those techniques to selecting a stock. As mentioned, relative strength is the focal point, followed by timing. Looking at the charts of RYL and HOV, these stocks are in an established trend, and are trading near support. Based on the technicals, these would be a few of the trades that are easiest to manage from this list. Here are a few things to consider when selecting a stock: Top Down Analysis Page 7
Consider the strength and duration of the trend. Determine whether the stock is at support or resistance. Look for any continuation or reversal patterns. Use any additional technical indicators to help time the trade. Determine your risk in the trade, or where you would set stops. Execute a trade, following your trade plan. You may wish to add more filters to the methods outlined in this module. We encourage you to keep things as simple as possible, but each trader has their own preferences, level of risk tolerance, etc. What s important is understanding the value in a top-down approach to finding good trading opportunities. As mentioned earlier, there is no right or wrong method, but rather, there are methods that will suit you and your trade plan better than others. Aim to find the method that works best for you. Notes: Top Down Analysis Page 8