One of the key tenets successful traders follow is to strive to put as many factors in their favor each time they enter into a new position. One way to do this when considering an individual stock is to also consider industry group action. At any given time, certain industry groups lead market performance by outperforming other groups and the broader market indices such as the S&P 500 or Dow Jones Industrials Average. Other groups will either lag in terms of performance or move more or less in line with the broader market indices. Buying stocks in top performing groups or sectors is one way to improve a trader’s probability of long term success.
A Rising Tide Lifts All Boats
This phrase is often used to describe the effect of a bull market in the broader market averages. Yet this phrase is perhaps even more applicable when applied to the action of industry groups and the stocks contained within those groups. Certainly there will always be “outliers”, or companies that fail to perform well despite a good performance by their industry overall. But if you can identify an industry group that is performing well and/or is likely to continue performing well, in many cases buying almost any reasonably well-run company within that group can lead to good results.
The Effect of Fundamental Changes Within an Industry Group
Business conditions can change quickly for any given company or industry, often based on unforeseen events or circumstances. However, meaningful changes in the underlying fundamentals for a given industry will often take a long time to play out. If demand for the products and services offered by a given industry (automotive, technology, airlines, health care, etc.) increases, there is the potential for a strong, sustained performance by the overall industry in question.
The first phase might involve a few astute investors who recognize early on that the outlook for a given industry is about to improve. Slowly, almost imperceptibly and under the radar, the stocks of the companies in the industry group start to advance. After a while many more investors who track price movements begin to recognize that a large percentage of companies in a given industry are performing well. This will lead them to analyze the industry more closely and some will begin to invest in those companies.
Soon thereafter it becomes more widely recognized that this industry is experiencing good performance, both in terms of business fundamentals (earnings and sales) and rising stock prices.
After a while the companies in the industry begin to announce quarterly earnings and sales and some of these announcements may involve positive earnings surprises. These positive announcements may attract more fundamental traders as they begin to recognize that some very positive things are happening within the industry in question, possibly even better than expected up until now.
Eventually prices for stocks in the industry advance enough to qualify the industry as a top performer in terms of price movement relative to other industry groups. This can attract momentum buyers, i.e., traders who buy top performing stocks in hopes of “buying high and selling higher.” At first the buying may be focused on those companies that are perceived to the “leaders” in the industry. But after they have been bid up many traders will begin to look at other stocks within the industry group in hopes of finding one that is either undervalued or poised to grow its earnings considerably.
The process that we’ve just described can take anywhere from several months to several years or more to play out. In general, the more significant the positive change in fundamentals, the longer the process will take to play. For this reason it can be useful to look at industry group performance to see just how long a strong group has been performing well. If the fundamentals are strong and especially if the overall market is in an uptrend, an up-trending group can continue to rise for as long as several years at a time. For this reason, some traders will apply trend-following techniques such as moving averages to industry group action in order to keep themselves on the right side for as long as possible.
In addition to the direction and longevity of the trend, traders are also interested in the actual magnitude of price movements within a given industry group. Certain groups such as technology and biotech are historically more prone to make above-average movements in price. As we alluded to earlier, sometimes – especially when the overall market is in an uptrend - one of the best ways to find an industry group that will perform well going forward is to find an industry group that has already been performing well recently. While this is counter-intuitive to many traders, much research points to this as a viable strategy. That being said, remember also the adage that states, “trees don’t grow to the sky.” In other words, eventually even the best industries will “cool off” and traders must be prepared to deal with some ups and downs along the way.
Looking at Stocks Within an Industry Group
Once a trader identifies what they consider to be a favorable industry group, there are several potential strategies to choose from. One approach is to buy a variety of stocks within the group in order to hold a position that reflects the action of the overall group rather than just an individual company. A second possibility for aggressive traders is to focus on the top-performing companies within the group in hopes of maximizing their investment. A third possibility that a trader may consider – particularly if the group and the leading stocks within the group have already sustained an extended advance, is to look for second and third tier companies within the industry group that may be poised to take advantage of the industry’s improving fundamentals and to start playing catch up versus the industry leaders which they have previously underperformed. Another possible strategy is to buy a sector or industry ETF. This choice allows the trader to participate in the movement of an entire sector or industry without having to select individual stocks.
An old adage states that “it is not a stock market, but a market of stocks.” The point of this statement is simply that stock traders must ultimately select individual stocks that go up in price in order to succeed. However, it can also be stated that “it is a market of industries”, with any number of companies competing within a particular industry.
Giving some consideration as to what industries are performing the best and are likely to continue performing well, can be a great place to start when looking for individual stocks.