Understanding Sector Analysis

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First, let's define what we mean by sector. It is a group of stocks in the same industry. Examples of sectors include semiconductors, banking, and so forth. With that understanding, let's consider when we move to sector analysis. As I explained, my trading methodology favors the long side. We 'll start with the bottom that formed in June 2006 on the NYSE. (A complete analysis of how that low was identified will be given in Chapter 3 i ) For now, to help simplify matters, assume that we have identified the bottom at the June 2006 low, and we are now bullish based on the view for the next three to six months. With this long-term view, we have a chance to trade profitability from the long side.

With the market in a bullish mode, our goal is to find the stocks that will appreciate the most, giving us the "biggest bang for the buck," so to speak. This is the most opportune time to be bullish, since most stocks are coming off a low point and are relatively cheap. (If you want to buy stocks on margin, I believe this is the only time it would be safe to do so.)

So how do you pick stocks that are the best positioned to appreciate the most for the next three to six months? First of all, the initial step is not to pick the stock. Rather, you find the strongest sector within the overall market. Then you pick the best stock in that sector.

This two-step process will get you closer to your goal of picking the strongest stock more quickly and easily. There are thousands upon thousands of stocks in the market, and picking the one that is likely to appreciate the most is a monumental task. However, there are only 36 or so sectors (depending on how the sectors are broken down). This is a much easier number to deal with.

Sector Strength Grouping stocks into sectors and then running scans to find the strongest sectors saves both time and energy. Using the June 2006 scenario, we already know the time is right because, looking at the big picture and a long-term time frame, we know the market has made a bottom. Now the time is right to find the best sector and the best stock within that sector.

Sector strength can be identified by studying what happens to that sector in a declining NYSE market. Strong sectors will drop less on a percentage basis compared with weak sectors; therefore, the sectors that hold up the best during a decline should perform the best when the next rally phase begins. The rationale is a sector that doesn' t go down as much in a bear market should really fly when the overall market rallies.

The rule is that sector strength is identified by price strength in an overall market decline. This is analogous to the way an investor may pick one stock over another on a retracement of a previous up leg. One stock pulls back 50 percent of its previous up leg. Another stock only pulls back 38 percent of its previous up leg. The stock that pulled back the least on a percentage basis is the stronger stock. Identifying sector strength works the same way.

Figure 2.9 shows the S&P 500 Large Cap Index ($SPX). A strong rally in the S&P started in June 2006 and lasted into December 2006, amounting to nearly 200 points or a 16 percent gain.

Figure 2.10 is a sector comparison chart (found on www.stockcharts .com). It depicts what John Murphy, chief technical analyst of StockCharts .com, likes to compare in economic cycles. The nine sectors of banks, gold and silver, semiconductors, oil services, pharmaceuticals, S&P 500 retail, Internet, biotech, and brokers provide a good cross-section of the economy.

By charting these sectors, displaying one on top of another graphically, we can see which sectors hold up the best going into a market bottom. The sectors that went down the least in these market conditions should also

FIGURE 2.9 Chart of S&P 500 Large Cap Index Shows Rally from June 2006 to December 2006

Source: Chart courtesy of DecisionPoint.com.

FIGURE 2.9 Chart of S&P 500 Large Cap Index Shows Rally from June 2006 to December 2006

Source: Chart courtesy of DecisionPoint.com.

FIGURE 2.10 Major Market Performance Chart Compares Strengths of Various Sectors

Source: Chart courtesy of StockCharts.com.

FIGURE 2.10 Major Market Performance Chart Compares Strengths of Various Sectors

Source: Chart courtesy of StockCharts.com.

be the ones that perform the best during the next market rally. In other words, the sectors that went down the least in a down market should go up the most in an up market.

Notice in Figure 2.10 that the sector "banks" held up the best at the June 2006 bottom. In mid-December 2006, bank stocks as a group were up nearly 12.5 percent. However, compare the performance of the banks with the S&P. The S&P came from a couple of percentage points below the banks at the June 2006 low, and ended up at near the same level as the banks as of December 2006. That performance comparison shows why the S&P performed a little better than the banks.

The sector that performed the best in this time frame was the Internet stocks. The Internets started from a much lower low and showed weakness going into the June 2006 low compared to the S&P and the banks. However, the Internets rallied strongly and outperformed all markets. The reason why is not clear. However, this sector analysis method certainly did a decent job of picking one of the best sectors in terms of performance from the June 2006 low.

Sap 500 Large Cap Index (SSPXi (cj2007 DecisionPoirt.com

2005 Feb Mai Apr May Jun Jul Aug

FIGURE 2.11 S&P 50 Large Cap Index Shows Rally from April 2005 Low to August 2005 High

Source: Chart courtesy of DecisionPoint.com.

Figure 2.11 shows another time frame—low to high—from April 2005 to August 2005. The S&P 500 covered 100 points in that time frame, or a gain of about 9 percent.

Going into the April 2005 bottom, as Figure 2.12 depicts, the two strongest sectors that held up the best were oil services and pharmaceuticals. Oil services did the best by appreciating 28 percent, while pharmaceuticals did not do as well, breaking about even.

This example shows why sector analysis is very important. It's always wise to pick two or three sectors to invest in at the lows to spread the risk; otherwise, there is a chance that the one sector that you are in may not perform. In this example, you would have made money in oil services but broke even in pharmaceuticals.

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