What You Need To Know About Stock Sector Analysis
Many years ago when I first started trading I was completely oblivious of stock sector analysis. I was under the impression that each stock traded completely independent of other stocks. My logic was based on the fact that each company is a separate entity and doesn't really have anything to do with other corporate entities. While my logic made rational sense it made no sense to the reality of how the stock market works.
The Importance Of Stock Sector Analysis
One of the first books I picked up when I first started out was How To Make Money In Stocks, by William O'Neil. Truthfully I didn't think much of the book when I first read it, but there was one page this one page that was in the middle of the book that had one paragraph that I couldn't get out of my head.
It's been over twenty years and I can't think of the exact wording but it alluded to the fact that individual stocks follow other stocks in that same sector over 70% of the time. I remember after reading that section, thinking to myself why why this author buried such important information in the middle of a book in one obscure paragraph.
Back when I started there were no ETF's. You had to do hours of research to find out which stocks were in each sector manually. Once every few weeks Investor's Business Daily would have a section that highlighted a different sector group and provided the stocks that made up that sector. In today's day and age you simply have to go to Google and do a simple search for ETF's or visit Yahoo financial for a list of different sectors, ETF's and stocks that make up each ETF.
I typically begin my analysis of sectors by looking at industries that went through a long trend in recent years. I want to find sectors that have been beaten up and are ready to make a comeback or sectors that are trading above 1 year highs. My goal is to find a market group and continuously monitor the stocks in that sector for pullbacks away from the main trend.
One sector I'm currently looking at is the house building sector. This sector has been beaten up during the last several years and is beginning to look like it's making a turnaround in recent months. Take a look at this chart of KB Home, one of the county's leading home builders in several states. The stock has been in a bear market along with all the other stocks in this sector for over 6 years now.
Notice the double bottom and the uptrend that began several months ago. Remember that this is a monthly chart which represents strong fundamental changes in the markets over several years. This is how you want to begin sector analysis with very long term view of the sector.
The second thing you need to do after you find a turnaround sector is to confirm that other stocks in the industry are following along or correlating to the first stock you examined. You want to make sure that other larger stocks in that sector are pretty much doing the same thing more or less. This is a very important step because when multiple stocks in the same sector are behaving the same way it demonstrates that there is a fundamental reason for their behavior. Markets will not follow or mimic each other for extended periods of time when there's no fundamental relationship or basis between the two companies. Take a look at this chart of D.R Norton stock, it's in the same industry group as KB homes and has a similar business model. If you look at the two companies you can see that they are trading very similarly to each other. I didn't do correlation statistical studies but I would bet the correlation is over 85 percent by looking at the graph of the two stocks.
The next step is to analyze both stocks together so you can see how they compare against each other in terms of strength and weakness. Notice we are deep into our analysis and we are still only looking at the long term view of the sector. By looking at the sector through a magnifying glass we can begin to see which stock is the best and worst candidate for short term set ups.
Stock sector analysis is best approached from a long term perspective. First isolate the sector you are interested in and then begin analyzing the strongest and weakest stocks in that sector. Once you identify the closest trading stocks, compare them side by side to see which one is the strongest and which one is the weakest out of the two. Once you go through this process, you can begin your short term trend analysis and actual set up conditions for the strongest and weakest stocks in each sector.
Next time I will show you where to go from here in your stock sector analysis.
Wishing you the best
By Roger Scott