Finding the right stocks and sectors

The top-down investment strategy is based on determining the health of the economy, the strength of different sectors, and then picking the strongest stocks within those sectors to maximize returns. If the economy is performing well, investors can choose the sectors as well as stocks within those sectors that are on the rise. Even if the economy isn’t performing well, there could be sectors and companies that are bucking the trend.

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

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. However, just because the market is moving higher doesn’t mean that all stocks will perform well, and some will greatly outperform others.

If we are in a bear market–or price declines–the investor could engage in short selling. Short selling is an advanced strategy that speculates on price declines in a stock and should only be considered by experienced investors. Short sellers identify and sell the stocks likely to perform the worst, and earn a profit as prices fall. However, the focus of this article will be on uptrends, but the same principles apply to downtrends.

Before choosing a sector or stock, investors should identify a trend using multiple time frames within charts. Investors can use charts to help define the trend for a sector or stock. It’s important to know the time frame or the amount of time that a trend has been existence. Trends can be grouped as primary, intermediate, and short-term.

However, there are multiple time frames to consider. For example, a weekly or monthly chart might show an uptrend while a shorter time frame–such as a daily–might show a correction. As a result, 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 running out of steam. It’s helpful to use a long-term chart to identify the trend and use the intermediate-term and short-term charts to help drill down the exact entry and exit levels. 

Certain sectors perform better than others, so if the market is heading higher, we want to buy stocks within sectors that are performing the best. In other words, we 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, we 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. Next, we choose the sector that is one of the top-performing sectors. Investors can choose a few of the top sectors to create diversification.

We can also view 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 the corrections). 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.

Once we’ve identified an uptrend in a sector that’s outperforming the market, we need to identify the stocks within the sector to buy. We could simply buy a basket of stocks reflecting the entire sector, which could perform reasonably well. However, we can 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. However, it’s likely a few of those stocks will outperform, and those are the ones we want in our 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 we want. Examine the charts of the top performers and place trend lines on the chart whereby the price trend should be clearly defined. Profit objectives based on chart patterns should be established to identify potential price gains while also considering the risk of losses.

It is important to note that there are other factors to consider when buying a stock. Additional criteria to look at include:

Liquidity refers to the number of shares being traded 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 with little volume 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.

Many investors shy away from high-priced stocks and gravitate towards low-priced stocks. It’s best to trade in stocks that are above $5, or preferably higher. This is not to say there are not “good” cheap stocks or not “bad” expensive ones, but do not avoid a stock just because it is expensive or buy a stock just because it is cheap in dollar terms.

ETF trading has come a long way over the years. If you do not want to hold multiple individual stocks, you may be able to find an ETF that will give you reasonably close results. There is no problem buying specific ETFs, if that is preferred, which can reasonably mirror what individual stocks would have been selected.

Of course, 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 with the market. Also, be aware of overtrading, which can result in excessive commissions; this why we use multiple timeframes.

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.

This strategy does require some turnover of trades, as 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, and if you are not opposed to short selling, being short in the weakest stocks that are leading the market lower during bear markets. We do this by finding the hottest sectors (for a bull market) over a period of time and identify the best-performing stocks within that sector. By continually transferring assets into the best-performing stocks, we stand a good chance to make above-average returns.