Before buying or selling a specific stock, it may be a good idea to analyze the sector in general. This approach allows you to use technical analysis to identify current trends and compare a stock’s movement against a basket of securities in the same market segment.
Comparing the trend for a sector versus the trend for a stock that is part of that industry can help you confirm its current momentum or raise doubts about it. For example, a rising stock in a bearish sector could be a warning of an impending downturn in the stock price. Generally, individual stocks tend to reflect the overall direction for their sector.
Different technical analysis tools allow you to assess the trend for a market, a sector or a specific stock. Of course, there are the lines that can be drawn by linking troughs or peaks, but there are also technical indicators such as the Relative Strength Index (RSI), the MACD, and moving averages which can also help. In the following examples, we will use the combination of trend lines and a 50-period moving average to identify current trends.
Using a top-down approach, we begin by determining the trend for the market as a whole by analyzing stock indices. That way, we can confirm that the current momentum is generally rising. It is possible to assess the general mood of a market by analyzing changes in the value of the S&P 500 Index or the NASDAQ for the U.S. market or the TSX S&P Index for the Canadian one.
In this image, you can see that the S&P TSX Index is above the trend line and also above the 50-period average (blue line), indicating a rising momentum for the Canadian market. Note that the value for the index is very close to breaking through the rising trend line.
The next step is to identify sectors that are outperforming and supporting the rising market trend, as well as sectors spurned by investors that are performing below average. One effective way to analyze a particular sector is to find an ETF that contains a certain number of stocks in the same market segment. These types of financial instruments are called sector ETFs and various institutions sponsor them. For example, the S&P/TSX Capped Energy Index ETF (XEG-TC), listed on the Toronto Stock Exchange, is an ETF created by investment firm BlackRock that is exposed to numerous companies related to oil and natural gas extraction. You can infer that the XEG-TC ETF could be used to analyze the energy sector in the Canadian market. See the image below for the sector ETF chart.
Lastly, among the sectors of activity, it is possible to find out which stocks show the strongest momentum in the same direction and which are underperforming their sector. To continue with the previous example, we could compare the stock chart for Crescent Point (CPG-TC), an energy sector stock, against prices for the XEG-TC sector ETF.
When comparing a specific stock and the energy sector ETF, the first thing we can notice is the difference in their performance over the last 180 days. In the image above, you can see the performance of the XEG-TC ETF on the left of the chart (+20.68%) and CPG-TC’s stock on the far right (+70.45%). At a glance, you can already see that in terms of return percentage, the stock has significantly outperformed its sector.
The second element that requires particular attention is the changes in the price of the two securities. The XEG-TC ETF chart shows that the price closed below the rising trend line, indicating a sell signal for the sector in general. Despite the fact that CPG-TC’s share price is still above the trend line, you could expect the stock to eventually follow the same trend as the energy sector as a whole.
To wrap up, if you have a momentum-based investment strategy, it may be beneficial to use technical analysis to identify current trends to avoid taking contrarian positions. By comparing how a sector has performed with the trend of a stock within that sector, it is possible to better anticipate future movements in the share price. In other words, as a general rule, you can use the momentum of a sector as an indicator of the trend direction for the majority of the stocks that are part of it.
Author biography: Alexandre Demers has been an active investor since 2013 and is the founder and president of Traders 360 Inc. He has also authored the e-book “Investir à contre-courant” (Investing against the grain) and hosts the “Finance 360” podcast available free on Spotify and iTunes. His goal is to make stock trading more democratic and educate the public at large about the possibilities of self-managed investments.
The above article was written by Traders 360, an independent external firm partnered with National Bank Direct Brokerage.
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