One approach to market analysis is a "top-down analysis" that begins with a review of the market as a whole and then drills down into sectors, industries, and individual equities to narrow down potential stock candidates.
Step 1: Review market and index performance
Traders often use one or more of the major indices to track the market. An index is a list of securities representing either the market as a whole or some portion of the market. Any changes to the price of the individual stocks in an index decrease or increase the value of that index.
Indices can vary in performance over the same trading period. Monitoring and comparing index performance can provide you with important information when you’re looking for stocks.
Here are some of the more common market indices:
|The Dow Jones Industrial Average (DJIA/DJX)||Also known as "the Dow," the DJIA is a narrowly based index composed of 30 large-cap stocks traded on the New York Stock Exchange. The oldest index, the Dow is frequently cited as an indicator of the overall market. It uses a price-weighted methodology—that is, each stock affects the index according to its market price.|
|Standard & Poor’s (S&P) 500 Index||A broad-based index of 500 stocks, the S&P 500® is chosen by a committee based on factors such as market capitalization, industry, and liquidity. This index uses a market-capitalization-weighted methodology—each stock affects the index according to its market price and shares outstanding. Because the S&P 500 includes many more stocks than the DJIA, many consider it a better representation of the U.S. market as a whole.|
|NASDAQ Composite Index||Composed of over 3,000 common stocks and similar securities traded on the NASDAQ exchange, the NASDAQ Composite Index uses a market-capitalization-weighted methodology—that is, each stock affects the index according to its market capitalization.|
|Russell 3000® Index||This index is composed of the 3,000 largest U.S.-traded stocks, representing approximately 98% of the investible U.S. equity market. Like the NASDAQ Composite Index, the Russell 3000 uses a market-capitalization-weighted methodology—each stock affects the index according to its market capitalization. Unlike the NASDAQ Composite Index, the Russell 3000 only includes securities that are incorporated within the U.S. The Russell 2000® Index is a commonly traded subset of the Russell 3000® Index.|
Reviewing these indices can shed light on the direction of the market overall. Are the indices increasing? How long has the trend been in place? How well are the indices aligned?
Step 2: Review sector and industry performance
Sectors are subsets of the market, composed of stocks that share common characteristics. Companies within each sector produce similar goods and services. Sectors are further divided into groups, industries, and sub-industries based on more granular criteria. These 10 sectors that make up the Standard & Poor’s Global Industry Classification Standard (GICS) include 24 industry groups, 67 industries, and 147 sub-industries:
Standard & Poor’s GICS sectors
By tracking the performance of stocks across sectors and industries, you can take a deeper look into the market to identify areas of potential strength and weakness. You’ll have the information available to help determine whether there’s broad movement in the market, with many stocks participating, or narrow activity that’s confined to a few sectors or industries.
Keeping a close eye on sector performance can help narrow down searches for trading opportunities and measure a sector against other sectors.
Just as the overall market is affected by a variety of underlying factors, stocks in a similar industry can be influenced by the same issues. You’ll be better prepared to assess a company’s relative worth if you have a basic understanding of its industry.
Step 3: Review technicals, fundamentals, and company news
If you’re interested in a particular sector, the next step is to identify potential companies for your investment. Stock-screening tools sift through all the stocks in a sector. Fundamental and technical analysis screening criteria are commonly used to search for companies that match investing criteria.
Company news can impact market sentiment and influence your stock choices. Each sector has its own set of business drivers. Understanding these may help you better evaluate a firm’s prospects.
Analyzing the market from the top down is a popular way to find opportunities. Begin by identifying the prevailing trend of the market and then drill down from there. Use sector analysis to focus on how different parts of the overall market are performing, both relative to the overall market and to other sectors. With a top-down approach, you don’t need to concern yourself with the details of a specific company until you’ve established that the market and sector are in sync.
If you do happen to have a specific stock that you’re interested in analyzing, you can follow an approach that is similar to a top-down approach, with a few modifications.
The first step would be to review the fundamentals and company news of the individual stock, then assess the technical picture according to your desired holding period. If you find that those support your view of the stock, then consider adding the stock to your portfolio as long as the overall market and sector conditions are favorable.
As with any form of analysis, make sure you’re being as consistent and objective as possible.