11. USING A TOP-DOWN MARKET APPROACH

The idea of beginning one’s analysis with a broader view and gradually narrowing one’s focus has another important application in the field of market analysis.That has to do with utilizing a “top-down” approach to analyzing the stock market. This approach utilizes a three-step approach to finding winning stocks. It starts with an overall market view to determine whether the stock market is moving up or down, and whether this is a good time to be investing in the market. It then breaks the stock market down into market sectors and industry groups to determine which parts of the stock market look the strongest. Finally, it seeks out leading stocks in those leading sectors and groups. 


THE FIRST STEP: The Major Market Averages
The intent of the first step in the “top-down” approach is to determine the trend of the overall market. The presence of a bull market (a rising trend) is considered a good time to invest funds in the stock market. The presence of a bear market (a falling trend) might suggest a more cautious approach to the stock market. In the past, it was possible to look at one of several major market averages to gauge the market’s trend. That was because most major averages usually trended in the same direction. That hasn’t always been the case in recent history however. For that reason, it’s important to have some familiarity with the major market averages, and to know what each one actually measures.


Different Averages Measure Different Things
The traditional blue chip averages—like the Dow Jones Industrial Average, the NYSE Composite Index, and the S&P 500—generally give the best measure of the major market trend.The Nasdaq Composite Index,by contrast, is heavily influenced by technology stocks.While the Nasdaq is a good barometer of trends in the technology sector, it’s less useful as a measure of the overall market trend.The Russell 2000 Index measures the performance of smaller stocks. For that reason, it’s used mainly to gauge the performance of that sector of the market. The Russell is less useful as a measure of the broader market which is comprised of larger stocks. Since most of these market averages are readily available in the financial press and on the Internet,it’s usually a good idea to keep an eye on all of them.The strongest signals about market directions are given when all or most of the major market averages are trending in the same direction (See Figure 11-1).


THE SECOND STEP: Sectors and Industry Groups
The stock market is divided into market sectors which are subdivided further into industry groups. There are ten market sectors, which include Basic Materials, Consumer Cyclicals,
Consumer Non-Cyclicals, Energy, Financial, Healthcare, Industrial, Technology, Telecommunications, and Utilities. Each of those sectors can have as many as a dozen or more industry groups. For example, some groups in the Technology sector are

Computers, the Internet, Networkers, Office Equipment, and Semiconductors. The Financial sector includes Banks, Insurance, and Securities Brokers. The recommended way to approach this group is to start with the smaller number of market sectors. Look for the ones that seem to be the strongest.During most of 1999 and into the early part of 2000, for example, technology stocks represented the strongest market sector. Once you’ve isolated the preferred sector, you can then look for the strongest industry groups in that sector.Two leading candidates during the period of time just described were Internet and Semiconductor stocks. The idea is to be in the strongest industry groups within the strongest market sectors (See Figure 11-2). For many investors, the search can stop there.The choice to be in a market sector or industry group can easily be imple-

mented through the use of mutual funds that specialize in specific market sectors or industry groups.


THE THIRD STEP: Individual Stocks
For those investors who deal in individual stocks, this is the third step in the “top-down”market approach. Having isolated an industry group that has strong upside potential, the trader can then look within that group for winning stocks. It’s been estimated that as much as 50% of a stock’s direction is determined by the direction of its industry group. If you’ve already found a winning group, your work is half done. Another advantage of limiting your stock search to winning sectors and groups is that it narrows the search considerably.
There are as many as 5,000 stocks that an investor can choose from. It’s pretty tough doing a market analysis of so many mar-

kets.Some sort of screening process is required.That’s where the three-step process comes in.By narrowing your stock search to a small number of industry groups, the number of stocks you have to study is dramatically reduced.You also have the added comfort of knowing that each stock you look at is already part of a winning group (See Figure 11-3).