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Top Down style analysis is used by professional investors, traders and analysts the world over. The variety of people that use this method is equalled by the number of techniques that can be implemented within it, including almost any approach you can think of within technical, fundamental, sentiment or economic analysis.
So what is Top Down analysis? Well, it involves starting at the top level of a pool of instruments you have available to you. For an international equity fund manager this could be looking at the key stock indices for each country, then the sectors within the countries that show promise and finally the stocks within those sectors.
For those who only want to trade stocks in one country, the analysis starts with its major, broad market index. For the US this will often be the S&P 500. For Australia, it’s the S&P ASX 200 or the All Ordinaries. Attention then moves to the main sectors within the market and finally to the stocks within the sectors identified. Again, the actual analysis techniques that can be implemented at each step are almost limitless.
Another approach is to begin with major commodities like Gold, Oil or Sugar just to name a couple and then move to stocks directly affected and positively or negatively correlated to their movement.
For the purposes of this exercise, let’s stick with the US stock market. Figure 1 shows indices based on the 10 major economic industry groups of the market.
Figure 1 – Major US Economic Sector Indices
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At this point the idea is to analyse each index and gain a directional view. Then take the strongest and/or weakest sectors based on that directional view and drill down into the individual stocks within them.
For arguments sake, let’s say that you are bullish on financials. Figure 2 below shows financials generally underperforming the SPX since April based on the Relative Strength Comparison (RSC) Indicator and then more recently breaking out to the upside as highlighted by the Bollinger Bands.
Figure 2 – DJ US Financials Index
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Having chosen the financial sector as our area of focus, we now drill down into the list of stocks that make it up. It is at this point that market scanning tools become invaluable. While there is really no need to run scans at a sector level – as there are only 10 major sectors to analyse, at a stock level there are hundreds or in this case thousands of potential stocks to choose from.
The stock selected in this case is Prudential Financial (PRU) which is a life insurance stock in the insurance sector. This stock has also underperformed the SPX over the last few months, but has not broken out as much as DJUSFN based on the Bollinger Bands.
Figure 3 – Prudential Financial
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As mentioned, the list of analysis techniques you can use is almost endless. When in doubt though, keep it simple and focus on what you know. If you are new to stock market analysis, read as much as can on the topic and look to gain an understanding of technical, fundamental, economic and sentiment based approaches.
In this month’s HUBB Self Directed Investor I’ll be demonstrating how to set-up ProfitSource for sector based analysis as well as how easy it is to apply in Integrated Investor with added Pre-computed Sector feature.
Happy trading
Jordan Craw
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