A stock selection approach that involves starting the study by looking at macroeconomic factors
The top-down analysis is a stock selection approach that involves starting the study by looking at macroeconomic factors, such as GDP, inflation rate, employment, trade balances, taxation, interest rates, currency movements, etc., before working the way down to microeconomic factors and single stocks.
This type of analysis identifies the countries with the fastest-growing economies.
For example, if economic growth in Europe is better than in Asia, investors will buy Exchange-traded funds that track specific European countries.
If a country's GDP shows constant growth, it indicates good performance. But, along with that, the geopolitical and financial stability of the economies should be taken into account.
The economic indicators and stock market index help to determine whether the economy is in an uptrend or downtrend and whether it is the right time to invest or not.
For example, the 50-day and 200-day moving averages help to determine the current market trend.
Then the search is narrowed down to analyze the general market conditions to spot high-performing sectors, industries, or regions within those countries that are predicted to outperform the market.
The pros and cons of specific sectors are also examined. Finally, the long-term prospects of the sectors are also predicted.
The economy's growth is often driven mainly by a particular sector of the country. Therefore, if investor diversifies their investment across other sectors, they may not get the highest possible returns they would have earned by making a targeted investment.
Then investors look at the fundamentals and technicals of these companies before making an investment decision.
The fundamentals help to identify the undervalued assets, and the technicals show support with an increasing trend in pricing. Thus, these investors bet on outperforming economic regions rather than specific companies.
However, they usually capitalize on Exchange-traded funds (ETFs) rather than individual equities. They might review other macroeconomic factors like economic or business cycles as well.
This approach helps save time as investors don't have to go through the financial statements of hundreds of companies as this approach reduces their data pool.
However, top-down investors will miss these opportunities if a fast-growing company is in an underperforming sector.
Macroeconomic Factors Relevant to Top-Down Analysis
Gross Domestic Product (GDP)
Usually, the top-down approach starts with comparing the Gross Domestic Product (GDP) of various countries, as it is a good and comprehensive indicator of economic growth.
The investor can narrow its search by taking only countries with constant GDP growth. However, other factors should also be considered.
Investors also consider the political climate of a country before deciding to invest in it.
Political unrest in a country or neighboring countries that impacts its economy exposes investors to risk losses due to stock market volatility. For example, the 2022 Russian invasion of Ukraine has caused stock market volatility across the globe.
The top-down analysis looks for geopolitical stability in a region before investing.
Asset Condition Investment
Investors must value assets for the company's economic growth. They should take precautions not to overvalue the concerned assets.
Local Currency Climate
A company may be doing well and have fast-paced growth in its local currency but may not perform well after considering the depreciation to convert it into US dollars.
Thus, before parking their funds, an investor must consider the inflation of the concerned economy.
Benefits and Drawbacks of Top-Down Investments
Top-down investing helps to choose a stock and the amount of investment according to the market conditions of the economy.
For example, if a stock has solid fundamentals but performs in a bear market, top-down investors will not consider it for investment. On the other hand, if the person had followed the bottom-up approach, they would not have been cautioned about the state of the economy before considering the stock for investment.
It prevents investors from over-investing. In addition, the portfolio will be diversified among all the leading foreign markets.
Investors can choose the ideal instrument according to the market and economic conditions. This method is particularly beneficial in a weak market.
Top-down investing involves a lot of research into different economies and the top sectors in those economies, thus minimizing the risk. In addition, it helps in identifying opportunities in sectors and regions that bottom-up investors may not consider.
This method narrows down the amount of stock that has to be considered for investment and thus saves a lot of time.
Top-down investors look at the global economic scenario. This is because they are familiar with the global environment, which helps to know the effect of an event in a particular economy and thus are not caught off guard when the market downtrends.
If global research is incorrect, the investor will miss opportunities.
For example, suppose they predict that an economy will continue to downtrend but an uptrend because of the lower or no exposure of the portfolio to the securities in that market. In that case, the investor will miss out on possible gains.
If the investor eliminates a sector from the investment, then even the top-performing companies in that sector will be destroyed. Top-down investors may also miss out on the opportunity to invest in undervalued stocks during a bear run.
The macroeconomic factors are complex and continuously changing. Thus, conducting a top-down analysis requires much study and is difficult to perform.
Top-Down vs. Bottom-Up Analysis
In the bottom-up approach, investors first analyze the fundamentals of individual companies and then take a deeper look at them by checking the external factors before making a portfolio.
Top-down investors focus on macroeconomic factors, while bottom-up investors focus on microeconomic factors.
Top-down investing is broader than its counterpart. For example, the bottom-up approach is more fundamental, while top-down investors try to exploit opportunities that follow market cycles.
Top-down portfolios might include commodities, currencies, etc., along with individual stocks, whereas bottom-up portfolios usually include individual shares only. So, both types of analysis have pros and cons, and no single approach is suitable for all investors.
So, combining these strategies is the best way to take advantage of all opportunities.
For example, an investor can start with the top-down approach and search for a country with strong macroeconomic indicators.
Then, they can take the bottom-up approach within that country by looking at the fundamentals like price-to-earnings ratio or return on investment of potential investments.
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Researched and authored by Harveen Kaur Ahluwalia | LinkedIn
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