When I first started trading many years ago, I was completely oblivious to stock market sector analysis.
I was under the impression that each stock traded independent of other stocks.
My logic was based on the fact that each company is a separate entity that doesn’t have anything to do with other corporate entities.
But while my logic made rational sense, that’s not the reality of how the stock market actually works.
The Importance of Stock Market Sector Analysis
One of the first books I picked up when I started out was “How to Make Money in Stocks,” by William O’Neil.
I didn’t think much of the book — or stock market sector analysis — when I first read it. However, there was one page in the middle of the book I couldn’t get out of my head…
It was actually one paragraph to be exact…
It’s been over 20 years now, so 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.
After reading this section, I remember thinking to myself, why did this author bury such important information about stock market sector analysis in the middle of a book in one obscure paragraph?
Taking the First Step
Back when I started trading, there were no ETFs.
Traders had to do hours of research to find out which stocks were in each sector.
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 can simply use Google and research ETFs or visit Yahoo Finance for a list of different sectors, ETFs and stocks that make up each fund.
Stock Sectors Traders Should Focus On
I typically begin my stock market sector analysis 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 one-year highs.
My goal in my analysis is to find a market group and continuously monitor the stocks in that sector for pullbacks away from the main trend.
The Real Estate Sector
One area I like to look at is the house-building sector.
This sector was beaten up during the early 2010s, but it looks like it’s making a turnaround in recent months.
Take a look at this chart of KB Home (NYSE: KBH), 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 six years now.
Notice the double bottom and the uptrend that began several months ago. Remember, this is a monthly chart which represents strong fundamental changes in the markets over several years.
This is how you want to begin stock market sector analysis — with a long term view of the sector.
Compare to Other Stocks in the Same 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 an 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 DR Norton Inc. (NYSE: DHI), it’s in the same industry group as KBH and has a similar business model.
If you look at the two companies you can see that they are trading similarly to each other. I didn’t do correlation statistical studies, but I would bet the correlation is over 85% by looking at the graph of the two stocks.
Analyze the Relative Strength of Both Stocks Together
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 stock market sector analysis and 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 setups.
Things to Keep in Mind
Stock market sector analysis is best approached from a long-term perspective.
First, isolate the sector you’re 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 is the weakest of the two.
Once you go through this process, you can begin your short-term market trend analysis and actually set up conditions for the strongest and weakest stocks in each sector.
All of the best,
Senior Strategist, WealthPress