Top Down Analysis involves determining which stocks have the particular combination of factors – technical, fundamental, economic or political – that constitute a profitable trading opportunity. Top Down methods and tools vary according to the market in question, but in all cases the process begins at a macro level and narrows down to individual stocks. The common theme is the big picture.
This usually means starting with major global indices like the Dow Jones 30, S&P 500, FTSE 100 or commodities like Gold, Copper, Oil or Zinc. The macro analysis can run from business cycles, commodity cycles, interest rates and currencies to government policies and world climate.
Once a macro perspective has been established you turn to the sector level, where the strength of stock types is analyzed. For the Australian Stock Market, you would look at the following key Industrial Sector Indices:
XDJ – Consumer Discretionary
XSJ – Consumer Staple
XEJ – Energy
XFJ – Financials
XIJ – Information Technology
XHJ – Healthcare
XMJ – Materials
XNJ – Industrials
XTJ – Telecommunications
XUJ – Utilities
It may seem that this level of analysis is only relevant to sectors that show strength or weakness based on the macro analysis. However, to help avoid “curve fitting” – or “seeing what you want to see” – sector analysis should be done independently of macro analysis. This will help avoid being bullish, bearish or neutral due to preconceived ideas.
From the Global and Sector levels you move to individual stocks. As before, performing stock analysis independently will help you avoid manufacturing reasons to take a trade. This third level of analysis can be done using market scanners or screeners across all stocks or only on blue chips.
Once each of the three levels of analysis has been performed, the results are compared. The aim is to find situations in which the information is in agreement. One example might be that bullish signals are found on Oil, the Energy Sector and Woodside Petroleum (WPL).
Moving from a macro economic level to a micro economic level can reveal strong opportunities on individual stocks. With the current market volatility, Top Down analysis can make the difference between profit and loss. As they say, “It’s better to own the worst stock in the best sector than the best stock in the worst sector!” Top Down can lead you to smart individual choices, whatever the overall market is doing.