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There is an old saying that ‘birds of the same feather flock together.’ In financial markets, this is particularly true.
Behind this groupthink is pure human psychology. Investors think in concepts; they act in concert. If the sentiment is bullish on a theme, why stop at buying a single stock? Surely more money could be made by buying the whole sector.
Indeed. The fact that investors are enamoured by FAANGS (or BRICS) show the pulling power of investment themes. Funds have been setup to do this sort of group investments for investors.
Another force behind group movements is risk consideration. Smart investors care about diversification. They know that picking the ultimate winner in a bull market is difficult. So they buy the whole thing – either with index or sector ETFs (exchanged traded funds), or the largest, or most profitable, or the highest-yielding stocks within the sector. This way, some individual stock-picking risks are reduced.
The third factor driving sector-wide moves is the channeling of accumulated profits. If stocks A,B,C are in the same industry and A‘s share price suddenly tripled, investors of A will now have excess profits to play with. They can either take profits, do nothing, or increase exposure to the sector via higher leverage. Human nature, often drive by fear and greed, dictates the latter. So investors of A will likely use profits from A to buy B and C, thus pushing up their share prices.
A pertinent example of this is the Cryto-Currency boom in 2017. As Bitcoin’s price surged ten-fold, wealthy Bitcoin owners went in search of new opportunities in the same sector. This triggered a frantic buying of other currencies, sending their prices stratospheric.
Initiating Sector Analysis
How does one identify a sector that is about to take off? Conducting a group analysis is straightforward. The first few steps are:
One, know the broad sectors within the equity market. According to the Global Industry Classification Standard (GICS), there are eleven industry groupings* (see below). Obviously, some markets are stronger in certain sectors. For example, British equity markets are inclined towards financials and property while Germany is stronger in industrial groups. In the US, the technology sector is extremely large and powerful.
Two, know the sector indices (if any) and its constituents. This is important because within a broad sector there are many subsectors. This binds stocks even closer. For example, within the Financial sector there are banks, asset managers, insurance, brokerages etc. Stocks within a subsector have a higher correlation.
Three, know the sector ETFs (if any). This is to build an investable universe.
Questions for Sector Analysis
Once we have the above information, we can conduct the actual group analysis. In particular,
- Which GICS sector is performing? Rank their simple returns (e.g., 2/4/10/26/52-week performance)
- For each GICS sector:
- rank constituents by their simple returns (2/4/10/26/52-week).
- calculate which constituents have been making upside or downside breakouts (as discussed earlier).
- calculate which constituents above or below their long-term, medium-, or short-term moving averages (ase discussed earlier).
- calculate constituents are making unusual price patterns (such as dynamics or gaps).
- Which stocks are the sector leader? Which stocks are the sector laggard?
- Which subsectors within GICS sector is doing well?
Once these questions are answered, you will know (roughly) which sectors are performing or underperforming against the market, and which stocks are doing well in each sector.
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Example – UK Housebuilders
In the chart below, we plot the performance of UK housebuilders stocks since the Brexit Referendum (24 Jun 2016). First, it is clear that these stocks moved together. Note the timing of their advances. Secondly, not all stocks peaked at the same time – even if they’re in the same subsector. Some earlier; some later. Third, a stock’s relative performance tend to persist. For example, Barratt has been underperforming the sector since Nov-’17; while Redrow has been leading the sector higher since Feb-’17.
Group analysis is an important part of market examination. Simply because it leads naturally to mob psychology and crowd behaviour analysis. At the heart of Group Analysis is this: Buy strength, avoid weakness. All the techniques we have discussed above lead to this strategy. Once a leader is identified, ride with it until its trend run out of strength.
*GICS Sector Groups: Industrials, Financials, Technology, Consumer Discretionary, Consumer Staples, Telecommunications, Energy, Materials, Healthcare, Utilities + Property.
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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.
Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.
Jackson has a PhD in Finance from Durham University.