Finding the Right Stocks and Sectors

A top-down investment strategy is based on determining the state of the overall economy as well as the strength of its various sectors, and then picking the strongest stocks within those sectors to maximize your returns.

Even if the overall economy isn't performing particularly well, there will be sectors and companies that buck the trend.

Investors can attempt to earn better-than-market returns by pinpointing the hottest sectors leading the market higher and then identifying the best stocks within those sectors.

Understanding Stock- and Sector-Picking

The markets may be moving higher but that doesn't mean that all stocks will perform well, and some will greatly outperform others.

If your analysis shows that the market is in an uptrend–called a bull market–and it's likely to continue for some time, you want to buy stocks that are showing the best potential to be big winners.

If we are in a bear market–when the market indexes are declining–there will still be winners as well as losers.

Chart Multiple Time Frames

Before choosing a sector or stock, investors should identify a trend using multiple time frames within charts. Investors can use charts to define the trend for a sector or stock. Trends can be grouped as primary, intermediate, and short-term.

For example, a weekly or monthly chart might show an uptrend while a shorter time frame–such as a daily–might show a correction. Watch out for conflicting trends within a sector or stock when analyzing multiple time frames.

Be sure to identify the primary trend and whether it appears to be strong or seems to be running out of steam. It's helpful to use a long-term chart to identify the trend and then use intermediate-term and short-term charts to help drill down the precise entry and exit levels you want to set. 

Pick the Right Sectors

In any market conditions, certain sectors perform better than others. You want to invest in sectors that are outperforming the overall market.

For example, the technology sector might be up 10% versus a 3% rise in the overall market, as measured by a benchmark such as the S&P 500 index.

By analyzing several time frames, you can pick the hottest sectors that are not just performing well right now but have been showing strength over a longer period. The time frames that investors choose will depend on their investment time horizon.

Investors can choose a few of the top sectors to create diversification.

You might also look at the chart of an exchange-traded fund (ETF) for a particular sector. The ETF would contain a basket of securities that track the stocks within a sector.

The trend should be defined by a trendline, with the ETF showing strength as it rises off the line. The trendline merely connects all of the higher lows in an uptrend (or the low points in a correction).

In an uptrend, each correction low should touch the upward sloping trendline. If the trend is continuing, there should be a bounce off the trendline and in the direction of the trend.

Pick the Right Stocks

Once you've identified an uptrend in a sector that's outperforming the market, you need to identify the stocks within the sector to buy.

You can simply buy a basket of stocks reflecting the entire sector, which could perform reasonably well. However, you could do better by cherry-picking the best stocks within that sector.

Just because a sector is moving higher does not mean that all of the stocks within that sector will be great performers. It's likely a few of those stocks will outperform, and those are the ones you want in your portfolio.

The process for identifying individual stocks is the same as the process for sector analysis. Within each sector, identify the stocks that have the greatest price appreciation using multiple timeframes to be sure that the stock is performing well over time. The stocks that have performed the best over two or three timeframes are the stocks you want.

Examine the charts of the top performers and place trend lines on the chart to clearly identify the price trend. Profit objectives based on chart patterns should be established to identify potential price gains while also considering the risk of losses.

Special Considerations

There are other important factors to consider when buying a stock. Additional criteria to look at include:

Liquidity

Liquidity refers to the number of shares being traded regularly so that a stock can be bought or sold with no delay. If there's liquidity, there are plenty of buyers and sellers.

Buying stocks that trade in low volumes makes it hard to sell at a fair price if quick liquidation is required. Unless you are a seasoned investor, invest in stocks that have trading volumes of more than a couple of hundred thousand shares per day.

Price

Many investors gravitate towards low-priced stocks for the satisfaction of owning a lot of shares.

There are good cheap stocks and bad expensive ones but do not avoid a stock just because it is expensive in dollar terms or buy a stock just because it is cheap.

That said, it's best to trade in stocks that are above $5.

ETFs

Exchange-traded funds (ETFs) have come a long way over the years. If you do not want to hold multiple individual stocks, you may be able to find a sector-specific ETF that will produce results for the sector you have identified.

ETFs can reasonably mirror the performance of the individual stocks that you would have selected.

Exiting and Rotating

There's no guarantee you'll make extraordinary returns, but this strategy does offer the chance to earn better-than-market returns.

Some monitoring of positions is required to make sure the sectors and stocks are still in favor. Also, be aware of overtrading, which can result in excessive commissions.

If your stocks or sectors begin to fall out of favor across the multiple timeframes, it's time to rotate into the sectors that are performing well–a process called sector rotation.

Your market analysis should guide you when to exit positions. When major trend lines within the stocks being held, or sectors being watched, are broken, it's time to exit and look for new trade candidates.

The Bottom Line

This strategy requires some turnover of trades, as the performance of the sectors and the leading stocks within those sectors will change over time.

The object is to be in stocks that are leading the market higher in bull markets, or exceeding the overall performance of a bear market.

This is achieved by identifying the best-performing sectors over a period of time and then identifying the best-performing stocks within that sector. By continually transferring assets into the best-performing stocks, you stand a good chance of making above-average returns.