WHAT IS TOP-DOWN STOCK ANALYSIS?

By: Sean Ryan

“Top-down” stock analysis involves analyzing broad economic trends, and selecting stocks based on how they should benefit (or suffer) from those trends. This is in contrast with “bottom-up” analysis, which involves analyzing individual companies, and basing investment decisions on more detailed company-specific data.

Some of the more common economic indicators used in top-down analysis include GDP growth, interest rates, currency exchange rates, and commodity prices.

For example, one may expect interest rates to rise, making it more expensive to borrow. This would be a negative for most stocks, but for some more than others. Banks, other financial companies, and real estate investment trusts (REITs) would be likely to underperform the market if expectations of rising rates are borne out.

Similarly, one might select stocks based on ones expectations for the prices of commodities such as oil. If you expect the price of oil to rise, that will tend to boost earnings at companies all along the oil production chain, from large integrated oil companies such as Exxon Mobil, who benefit since the oil they pump out of the ground is now worth more, to oil services companies such as Schlumberger, since higher oil prices will tend to drive more exploration activity.

Things are often not so simple, however. Frequently, macro economic trends will not unambiguously favor any group of stocks; like many things in life, they are double-edged swords. For example, when the economy is strong, banks tend to benefit from low levels of loans going bad. However, such an environment is precisely when it is most likely that interest rates will rise, potentially causing banks to suffer investment losses. Knowing which effect is larger at a given company makes the difference between a profitable and losing trade.

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