Top-Down Versus Bottom-Up Stock Analysis
As the name implies, top-down stock market investing involves looking at the big picture, typically the macroeconomic factors to stock selections. Bottom-up investing will look at the company-specific factors to choose stocks to buy or sell.
Each investment approach is distinct and comes with pros and cons. The top-down approach starts with a general overview (i.e., economic conditions) and works toward specifics (i.e., assets, sectors, individual stocks). The bottom-up approach begins with specific stock specifics and moves toward a general or broader market overview.
Advocates of top-down investing suggest it is simpler and less intensive. It allows for a broad economic general outlook and focuses on specific asset classes, countries, regions, sectors, and individual stocks where appropriate. It is in sharp contrast to the bottom-up approach, which focuses on the entire universe of stocks rather than on broad markets, industries, sectors, or specific countries.
Each investment approach has its pros and cons. The advantage of the top-down strategy is that it gives investors a broad understanding of general economic conditions, targeting specific assets, markets, sectors, and regions. The downside to this investment approach is investors may overlook the inherent differences between companies and sectors, resulting in missed opportunities. Stock market conditions and business/economic conditions may also deviate, creating confusion and lack of confidence. Also, economic indicators are not always accurate or correct since macro factors are complex and constantly changing.
Since the bottom-up analysis spends less time analyzing the general economic and broad market conditions, the approach requires investors to pay extra attention to micro and stock-specific factors. The pros are that this process will help investors quickly identify leading and lagging names in all different market conditions (i.e., bulls, bears, trading range, etc.). The approach forces the investors to focus on short-term opportunities and may not necessarily be as effective for longer-term investment outlooks. Because the bottom-up approach does not necessarily focus on macroeconomic factors, dramatic changes in economic conditions can adversely impact individual stocks. For instance, an economic contraction or a systemic shock to the financial system can lead to a broad bear market in stocks where everything falls in sympathy.
While the investment styles have pros and cons, a mixture may help investors maintain a balance of both. Combining the top-down and bottom-up approaches may help investors better navigate an increasingly challenging market environment this year.
We perform monthly technical reviews of the individual stocks in the Dow Jones Industrial Average (INDU), Nasdaq 100 Index (NDX), and S&P 100 Index (OEX). A bottom-up analysis is one way to maintain checks and balances on our top-down investment approach, keeping us honest and up to speed on things we missed in our macro strategy.
A summary of yesterday’s Technical Review of the S&P 100 Index (OEX) shows the market is converging toward a critical inflection point. In the 101 stocks that make up the OEX Index, there are 42 stocks rated Moderate Bullish (41.58% of the index), 36 stocks rated Neutral (35.74%), 22 names rated Moderate Bearish (21.78%), and 1 OEX stock rated Bearish (0.99%). Refer to the 5/31/22 Technical Review of OEX report for further information.
The shift from the Bullish/Moderate Bullish ratings toward Neutral/Moderate Bearish/Bearish ratings strongly suggests stock dislocations have accelerated. While every bear market is different, they tend to rhyme. One constant of a bear market is increasing stocks and market dislocations that lead to market risk and volatility. The recent rebound in stocks can still sustain for days, weeks, or months. The current rally is critical as the action will help decide if this is another bear market rally or something different.
Please review the bottom-up analysis of individual stocks within the OEX index and cross-reference against the following OEX analysis of the various market breadth and overbought/oversold indicators. The bottom line is that both investment approaches suggest that it is likely to become more challenging into the summer to early fall ahead of the mid-term elections. Will another 4-year mid-term election year cycle low develop?