Top-Down Investing by Harry Starn, Jr., CFA, CFP® Some portfolio managers and individual investors prefer an investment approach that starts with an analysis of the economy. Their premise might be explained as follows: “If the economy is improving then the business prospects of economically-sensitive sectors will improve; and, if the earnings of companies within those sectors improve so will the stock prices.” Perhaps this premise is easier visualized by using the Wall Street metaphor, “A rising tide lifts all boats.” If we know that a “rising tide lifts all boats” how do we know what the tide is doing? That is first step in top-down analysis. Is the economy rebounding from a trough? Are business conditions improving? Is the economic momentum sustainable? Is economic momentum slowing? The top-down analyst will try to assess where the country is by looking at economic data or polling the consensus views of economists. As an individual investor interested in looking at investments from a top-down perspective you might want to look are economic data for areas such as: Money and Credit Inventories Fixed Capital Investment Consumption, Trade Orders, Deliveries Prices, Costs, and Profits Production and Income Indexes Economy monetary aggregates vendor performance construction spending consumption spending inflation check manufacturing activity The above mindmap is designed to highlight some of the major areas of economic activity that might help identify economic trends. There is no need to track every statistic in every category; however, the investor may decide on a handful of indicators that he/she finds useful. Is the Fed lowering or raising interest rates? Are business inventories increasing or decreasing? What is the trend in consumer disposable income? Are stock market indices price levels increasing or decreasing? No one statistic is the most important, rather it is the overall “health” of the economy as defined by a combination of business activity, durable good, manufacturing, monetary policy, sentiment and stock market indicators that creates a meaningful picture. One well-known economic advisor that uses a top-down approach is Elaine Garzarelli. She became quite famous in 1987 because she put out a “sell” call a couple days before the 500-point crash. Her economic model, at least as I knew it, is depicted below: Economic Cycle Monetary Indicators Market Sentiment Market Valuations Garzarelli Model Earning Momentum Industrial Production momentum Coincidental/ lagging ratio Free Reservees Spread between S&P500 dividend yield and 3-month T-Bill rate T-Bill vs Discount Rate Interest Rate Momentum Shape of Yield Curve Money Supply momentum Money supply growth versus GNP growth Cash levels at mutual funds Number of bullish investment advisors S&P500 Earnings yield to interest rates S&P500 Dividend yield compared to 30-yr Treasury S&P 500 P/E ratio 21 points 26 points 25 points 28 points The model - which is probably somewhat different today – produces a number that falls within a buy, hold, or sell range. Do you see how economic data might be used by a portfolio manager? Well, if the top-down analyst can determine where the country is in terms of the economic (business) cycle then wouldn’t it be possible to position assets in those sectors of the economy that are positioned to outperform? Wouldn’t a sector rotation strategy be prudent whereby you would sell positions in sectors likely to under perform and buy positions in sectors likely to outperform? If you are a mutual fund investor, couldn’t you reposition some of your investment portfolio in sector funds that you or your financial advisor might think are set to out-perform? I think the following diagram was produced by Standard & Poors. I first saw it at a Chartered Financial Analyst Convention at Northwestern University over a decade ago when reviewing a Merrill Lynch study of sector performance in the 1980s. There are several interesting elements to the graphic. Note that there is an economic and stock market cycle. The actual economic cycle is shown in yellow while the stock market cycle is in blue. What the chart shows is that the stock market moves on expectations that are anywhere from six months to one year early. So, prices of transportation companies will start to appreciate before the actual economic recovery. Do you see how sector rotation strategies based on business cycles naturally flow from a top-down approach? So, as an individual investor how might you capitalize from this strategy? You might purchase a sector mutual fund or i-share (we will discuss these later in the course) or a leading company in the sector. Bob Froelich and Suze Orman recently wrote a book entitled, “Where the Money Is: How to Spot Key Trends to Make Investment Profits.” In the book there talked about a sector strategy that is not based on the business cycle but upon megatrends. Their premise is to identify major trends (or paradygm shifts) and to shift assets into those areas for long-term appreciation. Some of the trends that they talked about are: Pharma- ceuticals Education Energy Financial Services Global Infrastructure Discount retailers Technology Nanotechnology Sectornomics populations Health consciousness Prolonged life expectancy Key to knowledge and productivity Remote learning Consumption needs Asia's power surge Aging = higher savings rate Travel and entertainment Financial advisory services Global conectiv Wireless Global internet Price sensitivity of consumer E-retailing Driver of productivity Information superhighway Large-scale applications Gov't funding commitment So that is my summary on top-down analysis. My hope is that is gives you an introductory overview of the process. There are certainly many books written by established authorities that can help you increase your knowledge of the subject. Action Financial Planning, LLC. provides active management to qualified investors. Our asset allocation strategy is based upon modern portfolio theory and our active management approach uses fundamental and technical analysis. If our firm can be of service to you in building your financial security please contact us. Copyright Action Financial Planning, LLC. 2009. All rights reserved.