A Top/Down Approach
Top/Down analysis is a method often used by analysts in order to identify opportunities within larger trends. One technician that has been known for his Top/Down approach to markets is J.C. Parets, founder of All Star Charts. He recently made a short video where he explains to viewers exactly what Top/Down analysis is, and how he incorporates it into his process.
J.C. uses the visual below to help illustrate his Top/Down approach to stocks. It can be thought of like an inverted pyramid that starts with the big-picture trends and works its way down to focus on the smaller components.
The first step J.C. explains is to establish whether or not there is risk appetite for stocks as an asset class. In order to do this, we must look around the world and be sure to eliminate any home country bias. Doing this will give us a global macro perspective and tell us which countries are showing strength. Below is a list of over 50 different indices that J.C. analyzes at this step in his Top/Down approach. These represent some of the largest stock markets from around the world. By going thru the Daily and Weekly charts of each of these markets, J.C. is able to get an idea of the general risk appetite for stocks internationally.
After establishing which country is the strongest, J.C. then looks at the indices within that country. For example, if he found that US stocks were relatively strong he would then compare the indices within the US like the S&P, Dow, Nasdaq, Russell 2000, Transports etc.. This gives him a better idea of the trends and internals of the country being examined.
The next step is to hone in on the individual sectors within those indices. For example, we would compare Technology, Healthcare, and Financials side by side. This will give us an idea of which areas of the market we should be looking at. Going further, we can look at the sub-industry groups within the sectors. J.C. uses the Healthcare sector as an example and explains that the sub-industry groups within healthcare are vastly different.
The last step in Top/Down analysis is to look for individual names within the sub-industry groups, that present high risk/reward opportunities. For example, if Medical Device stocks are breaking out within the Healthcare sector it would be wise to look at an individual medical device stock like Intuitive Surgical ($ISRG) or Medtronic ($MDT).
I like to compare Top/Down analysis to using a microscope where you start by using a low-powered lens to get the general idea of how a specimen looks and then zoom in using a higher powered lens to get a more granular view. The brilliance of the Top/Down approach to technical analysis is that it tells you what type of market environment you're in and it produces micro opportunities that have been derived from larger macro trends. Make sure to watch the full video here.