Top Down Analysis in Stock Picking and Football

Originally published on Equities.com, October 11, 2016.

I am an American football fan. More specifically, I'm a Pittsburgh Steeler fan. My Mother, on the other hand, is not a Steeler fan. In fact, my mother is not a football fan, mainly because she is not a sports fan. Sports actually make a great analogy, and an easy way to understand the stock market concept of top down analysis. A good way to think of being a sports fan is that one is “bullish” if they would consider themselves a fan. With this idea of fandom being bullishness, think about sports as a broad topic.

There are many types of sports (baseball, football, basketball, hockey, golf, ect…) but if one is not a sports fan, there is a good chance they are not bullish on any specific type of sports. For arguments sake, let’s say that someone is bullish sports, and in particular, they are bullish on baseball. If someone is bullish on baseball, and bearish on football, then there is a pretty good probability they are not a Steeler fan. In order for one to be a Steeler fan, more than likely, they will have to be bullish on sports and bullish on football. The stock market is broken down in a very similar way. In a world of a few thousand stocks, how can I find the strongest of the strong, or the weakest of the weak with any consistency? Doing that requires a system, and top down analysis is a great tool for that system.

The market itself is a very broad topic, and typically, when we refer to market performance, we are referring to the performance of the S&P in general. If one simply wants to trade the entire market, then they could trade the SPY and achieve market performance. But if someone wants to trade a strong performing stock in a bullish perspective, how can they narrow it down to the best of the best?

One of the best ways is to break the S&P down into the performance of individual sectors over a given period of time. A three month period is an effective measurement for an investment that someone is looking to be in for a few weeks or a few months. An excellent proxy to measure the performance of those investments are the sector specific ETFs. There are a number of them, but the ones I use for comparisons are the Select Sector SPDR ETFs. These nine sectors are a good performance gauge over a given period of time.

Top down analysis explained in easy terms to understand.

The chart above shows the performance of the sector SPDRs performance for the past three months. This is simply a percentage change chart, with three months ago as the starting point. In looking at these sectors, it is easy to see that our strongest performing sector is the technology sector, which is up over 7.5% over that time.

In stark contrast to that performance is the consumer staples sector, which is down 6.1% in the same period of time. If I am looking for an individual stock to go long because I am bullish the market, I would then want to narrow my search down to those stocks in the technology field. However, if I had a bearish opinion of the market in general, I would look at the stocks in the consumer staples sector as potential shorting candidates. The overall idea is that I want the market, sector and individual security I am trading to all have the same direction. By doing this, I am increasing my probability of being a successful trader and greatly outperforming the market in general because I am using the power of correlations and top down analysis in all of my trades.

Originally published on Equities.com.

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