Understanding the basics of the top-down approach

The top-down approach allows you to understand the condition of the overall market, which is valuable because the majority of securities follow trends in the overall market. For example, if the stock market is dreadful and hits new lows every few weeks, you probably won’t find many great candidates to buy. On the other hand, if the market is roaring to new highs, choosing winning stocks is much easier because the wind is at your back.

Using this approach, you begin by determining if the market is overvalued or undervalued. Now, I wish I could tell you that the market is so efficient that when it’s overvalued, it quickly snaps back and becomes properly valued. Or that when it’s undervalued, it promptly snaps back and becomes properly valued. Sadly, this isn’t the case. Markets can become and remain over- or undervalued for significant periods of time — even years. For that reason, you evaluate whether the market is overvalued or undervalued on a fundamental basis, but put greater weight on the technical chart to swing trade.

After evaluating the market, you question whether the industry is likely to outperform or underperform the market. Finally, you look at the individual security to see whether its statistics are impressive enough to warrant investment.

Top-down analysis involves two specific steps:

1. Determine the state of the overall market — is it cheap or not and what direction is the trend?

   This step allows you to determine whether the overall market is cheap or expensive. As a swing trader, you don’t have time to call analysts, survey government data, and build an economic model that perfectly captures all information that may influence an overall market. Even if you did have the time for all that, I’ve never seen proof that such complexities improve forecasting abilities (my apologies to my statistics and economics professors). You look at some basic measures of market valuation, but at the end of day you must put greater weight on the technical picture to tell us whether to trade or not.

2. Assess the prospects of different industries in the market.

   This step helps you focus on promising industries so that the wind is at your back when you buy securities within that industry. If the market just bottomed, for example, you will want to focus on those industries poised to outperform the market. Being right on the overall market and wrong on the industry may leave you with losses.

Sizing up the market and examining the technical picture

You can’t identify good swing trading candidates with the top-down approach without first evaluating the overall market. Fortunately you can choose from three measures to determine whether the overall market is cheap, fairly priced, or expensive.

Just because a market is cheap or expensive according to these measures doesn’t mean you should ignore price action. Ideally, price action should confirm the findings of these measures. When it doesn’t, you should have less confidence in the staying power of the trend. For instance, these measures would’ve told you that the stock market was expensive or overvalued at the beginning of 1999. But that didn’t stop the Nasdaq Composite Index from nearly doubling during that year. The smart swing trader would’ve followed the upward price action. But he or she would’ve kept tight stops in light of the findings of these three valuation measures and, as a result, would’ve been better prepared for the ensuing collapse of the Nasdaq in 2000 that took prices lower by nearly 80 percent through 2002.

The models I present in the following sections are all yardsticks. They aren’t to be taken as fact. Stock markets can be over- and undervalued for long periods of time. But as a swing trader, you should know where value is. Even if you trade in the near term on the other side of value, you’ll know whether a trend has legs based on whether it goes against or with the direction of value. For example, the bull market in technology stocks in 1998 and 1999 was incredible and powerful. But it didn’t last long. Knowing that the market was overvalued — as all three of these indicators would’ve told you — would have prepared you for the major bear market that began in 2000 and ended in late 2002.

Taking the easy path: Long-term P/E ratio

The long-term P/E ratio method of determining whether a market is over- or undervalued is the crudest and simplest method you can use. It simply compares the market’s current P/E to its long-term average. The real question is: Do you look at the P/E based on the last 12 months of earnings, or do you look at it based on the expected earnings in the coming 12 months?

Reviewing the expected earnings over the next 12 months makes more sense than relying on historical earnings. After all, companies are valued based on their future, not their past. Historical earnings are especially unhelpful at points of inflection, where a major turn happens in the economy. The recent past looks very little like the coming future.

Fortunately, Standard & Poor’s (S&P) publishes the P/E of the S&P 500 Index based on both historical and future earnings. The S&P website (https://mena.spindices.com/indices/equity/sp-500) provides spreadsheets that show the P/E for the S&P 500 Index (large companies), the S&P 400 Index (mid cap companies), the S&P 600 Index (small cap companies), and the S&P 1500 Index (the broad market). To download these spreadsheets, go to the S&P website and click on the drop-down menu of Additional Info and select Index Earnings. The Excel sheet that automatically downloads has a wealth of info on the P/E ratio based on trailing 12-month earnings as well as estimated earnings for the coming 12 months.

From 1954 through 2018, the average P/E of the S&P 500 Index — which represents a large part of the market — has been 16.6 (see Figure 8-1). When the market trades significantly above this level (say 20 times earnings), that can indicate the market is overvalued. When the market trades well below this level, that may signal that the market is undervalued.

The S&P website breaks out data into two segments: as reported earnings and operating earnings. I recommend you use the operating earnings spreadsheet, because reported earnings can be distorted by one-time events that aren’t reflective of a company’s underlying fundamentals. One-time events that aren’t part of a company’s operations — like the gain generated from selling land or the loss suffered due to a hurricane — can distort a firm’s underlying strength or weakness. The operating earnings category ignores these one-time effects and examines only those earnings generated from a firm’s operations.

The long-term P/E ratio method has the following downsides when it comes to valuing a market:

• It ignores the other investment opportunities you can acquire. Stocks are one asset class and compete with other asset classes for investors’ dollars. When other asset classes offer investors low returns — say 1 or 2 percent — stocks tend to be valued at a higher premium to their historical average. A P/E of 15 may be cheap when interest rates are 1 percent. You can address this issue by combining the long-term P/E ratio with a method that looks at other types of securities, such as the two models addressed in the following sections.
• It may yield a result that won’t be reached for many months, or even years. Take a look again at Figure 8-1. Between 1996 and 2000, the market was overvalued based on long-term P/E but didn’t suffer a major correction for a few years. However, the eventual correction was swift and painful. That’s why you must use the long-term P/E ratio method in conjunction with price action (that is, technical analysis) when determining how to swing trade in a specific market.

• It isn’t useful as a short-term timing vehicle. The P/E model isn’t a short-term trading model and hence may hurt swing traders that depend on short-term price movements. It tells you the direction the wind is blowing, but sometimes the market ignores reality and marches the wrong way. Eventually, the market gets it right. But in the near term, this gap in accuracy may cost you a lot of money.

  Solve this lag by incorporating technical analysis with the P/E model. If the P/E model indicates that the market is undervalued but the trend is down according to the charts, don’t fight the tape. Instead, stay in cash or trade a different asset class. However, be alert for signals of a trend change. The near-term weakness may not be sustainable, and the market may be due for a rebound. Similarly, if the P/E model indicates the market is overvalued but the trend is definitively up, don’t argue with the market. Buy stocks, but keep tight stop-loss orders to protect yourself when the fundamentals prove out and the market takes a swoon. Be on the lookout for divergences in technical indicators.

The major indexes may be going in one direction while the majority of stocks are heading in a different direction. Believe it or not, the market indexes can be led by a small number of securities. Indicators such as the Advance/Decline Line or the New High/New Low Index can tip you off to a deteriorating or strengthening market when they diverge from the major averages. (The Advance/Decline Line and the New High/New Low Index can be plotted in most major charting programs, such as TradeStation and High Growth Stock Investor.)

Improving the ol’ standard: The adjusted Fed Model

The adjusted Fed Model compares the earnings yield on stocks to corporate fixed income securities. But you can’t compare yields to just any bonds; different types of bonds carry different levels of default. The higher the potential default, the higher the yield. It’s unfair to compare buying shares of Coca-Cola to buying a security issued by a troubled home lender likely to default on its obligations.

Rating agencies, primarily Standard & Poor’s (S&P) and Moody’s, measure the likelihood of a company defaulting on its obligations and assign rankings to different fixed income security. S&P’s scale ranges from AAA (representing the highest-quality companies) to D (representing ready-to-default securities). Moody’s scale ranges from Aaa (highest) to C (lowest).

Figure 8-2 highlights a table taken from Yahoo! Finance’s that breaks down the different rankings assigned by S&P and Moody’s. Investment-grade securities, which many institutional investors are restricted to investing in, have ratings between AAA and BBB on the S&P scale and Aaa and Baa on the Moody’s scale. These fixed income securities tend to be higher-quality and have a low risk of default. Fixed income securities that are below investment grade have a higher frequency of default (often higher than 1 percent).

When using the adjusted Fed Model, you should examine the yield on ten-year AA Corporate Bonds. These bonds are high quality, attract investment dollars from institutional investors, and represent a competitor to stocks. The higher the yield on corporate bonds, the less likely stocks are to be preferred over bonds. But don’t just take the yield of any AA-rated Corporate Bond. Instead, use a composite or average of all AA Corporate Bonds.

So where can you get this information? Fortunately, it’s provided free of charge at websites like the Wall Street Journal’s homepage (under “Market Data Center”). Figure 8-3 shows a snapshot from the Yahoo! Finance site that provides the yield on fixed income securities with different ratings and maturities (the term of the security). Notice that the yield on ten-year AA-rated Corporate Bonds is 5.60 percent.

Now that you know the yield on ten-year AA Corporate Bonds, you can compare that to the yield on stocks. Suppose the P/E of the S&P 500 Index is 19 today. That means the earnings yield is 1 divided by 19, or 5.26 percent. Using the information provided in Figure 8-3, you know that the yield on ten-year AA Corporate Bonds is 5.60 percent. Based on the adjusted Fed Model, stocks are overvalued relative to bonds because the yield on ten-year AA Corporate Bonds is higher than the earnings yield on the S&P 500 Index. As a swing trader, you should be alert for weakness in stocks.

As with the regular Fed Model, you can take this model one step further and calculate a fair value (what the fundamental analysis measures say the index should be trading at) of the underlying index by converting the yield on ten-year AA Corporate Bonds into a P/E ratio. A yield of 5.60 percent converts into a P/E of 17.86. To calculate the fair value, multiply the P/E of 17.86 by the expected earnings on the S&P 500 Index.

Assessing industry potential

Industries largely determine the profits of companies. Naturally, profits differ between Delta and United Airlines, but even larger differences exist between a grocery store chain and a PC manufacturer. Therefore, take special care in determining the attractiveness of an industry using fundamental characteristics.

You can identify which industries to focus on by looking at

• Historical performance: Certain industries tend to shine when the overall economy’s growing; others sparkle when the overall economy’s contracting. Technology stocks, for example, tend to do well when the economy is in its early or middle expansion period. Consumer cyclical stocks tend to perform well in late contraction (as the economy emerges from a recession). For suggestions on how to find this historical information, flip to Chapter 9.

• Industry fundamentals: Just as you determine whether a stock is cheap or expensive based on items like P/E, return on equity, and expected earnings growth rates, so too can you value industries based on these same factors. The two best places to get this information are Yahoo! Finance (free) and HGS Investor software (paid).

  Professor Aswath Damodaran of New York University maintains a wealth of data on industry groups on his website for free: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html.

  The following data can be reviewed for all industry groups in the United States from Professor Damodaran’s website:

  • Number of firms: The number of companies in the industry group.
  • P/E ratio: The P/E ratio of the industry group using trailing earnings or forward expected earnings (such a P/E ratio is called the forward P/E ratio).
  • Aggregate market cap/net income: This is an alternative measure to the P/E ratio using the total market caps of companies in the industry divided by the total net income of all firms. This measure is seeking to avoid misleading average P/E ratios that could develop from extreme values in the industry.
  • Aggregate market cap/trailing net income (only money-making firms): This ratio is similar to the previous one except that this measure excludes loss-making companies.
  • Expected growth – next five years: This gives the expected growth in earnings for the industry over the coming five years.
  • PEG Ratio: The PEG ratio compares the P/E ratio to the expected growth rate of the industry. The lower the PEG ratio, the more attractive the company or industry.

The PEG ratio is the best measure to use when looking for attractive industries. I like to sort all industries by PEG ratio and then focus on the top 20 percent of the industries. Keep in mind that earnings estimates change often. But you can still derive value from knowing what analysts estimate for earnings growth in the coming years.

Figure 8-4 is a snapshot taken from data downloaded from Damodaran’s website. Notice that the biotech industry has the lowest PEG ratio. The PEG ratio in Damodaran’s website uses the “aggregate market cap/trailing net income” measure, which excludes loss-making companies. Also notice that the P/E ratio for the biotech industry is 54 when looking at all companies and 17 when excluding loss-making companies. Biotech companies are often loss making; hence, there is a wide spread between the two P/E ratio measures. I prefer to look for industries where the P/E ratio isn’t materially different when excluding lossmaking companies or when including them.

From this list, I want to dig deeper into the auto and truck industries (which have high expected earnings growth rates) and software Internet (keep in mind that anything in the top 20 percent should be fair game). These industries show high expected earnings growth rates with P/E ratios that are low and not significantly different when excluding loss-making companies.

Additional data sources such as HGS Investor software and the MarketSmith service of Investor’s Business Daily (both paid services) provide earnings growth rates on a sector or industry basis as well as wider valuation measures (such as price to sales ratios or price to cash flow ratios). You should examine this information because industries experiencing the highest earnings growth rates and trading at the lowest valuation levels tend to outperform industries with low earnings growth rates and/or high valuations. These specific vendors can also assist you in identifying promising industry groups ripe for swing trading. By using these fundamental criteria in conjunction with the economic cycle chart in Chapter 9, you can determine which industry group is likely to perform best.

Just because an industry has attractive fundamentals doesn’t mean you can ignore the price action of that industry group. Instead, the price action (the chart and technical indicators) should be in alignment of the attractiveness of the industry.

After identifying the strong industry group you want to swing trade, drill down into the companies that make up that industry to find the most over- or undervalued candidate based on the Six Step Dance in Chapter 9.

Using screens to filter information

Fundamental screens can consider everything from earnings growth rates to average daily volume to changes in consensus earnings estimates. Sometimes this variety leads to information overflow, which may be discouraging if you’re using a fundamental screen for the first time. Fortunately, because you create your own screen using the criteria you want to focus on, you don’t need to bother with the premade, too-much-information batches vendors peddle to the public.

In addition to covering the general screening criteria to use, I delve into two screens: a growth-oriented screen and a value-oriented screen. I show you which criteria you really need to examine for each type of screen in order to sift effectively. Note: These screens are for illustrative purposes only to guide your development of your own screens. I recommend you specialize to enhance your trading. In other words, perhaps you’re a swing trader focused on high growth companies that have had a recent pullback on light volume. Or perhaps you focus on companies that just announced earnings exceeded estimates. You’ll be the best swing trader when you specialize in swing trading specific fundamental patterns. You don’t need to be a jack-of-all-trades (or jill-of-all-trades) to be a successful swing trader.

Keep in mind at certain points in time, growth stocks will outperform value. At other times, value will outperform growth. That doesn’t necessarily mean you should be shifting between the two screens. My recommendation is for you to focus on one type of screen that fits your trading pattern. If you excel at fundamental analysis, then focus on screens that speak to that advantage and use many fundamentally driven ratios. If you excel at technical analysis, use screens to narrow a list to charts that meet your trading criteria (whether you trade breakouts or whether you trade ranges. If you want to know whether one type of stock is outperforming another (say value over growth), you can use the techniques described in Chapter 6 to put together a ratio chart of value versus growth stocks.

Figure 8-5 highlights the one-year and five-year returns for growth and value stocks in the large (Russell 1000), mid (Russell Mid Cap), and small (Russell 2000) cap arenas.

Notice the striking differences in returns. Over the five-year period ending December 21, 2018, the Russell 1000 Value Index (large cap value) generated an annualized return of 5.71 percent versus the Russell 1000 Growth Index’s (large cap growth) 9.75 percent return. If you convert the annualized return (which is like an average return over the period) into a total return (how much the index rose in total over the five-year period), the figures look even more astonishing: The large cap value index rose 32.0 percent during the five years while the large cap growth index rose 59.2 percent.

You can see why knowing which horse is in the lead matters. When growth is in favor, as it clearly was during these time periods, swing trading growth stocks is like flying a plane with strong tailwinds. Swing trading value stocks can be profitable as well, but the headwinds lower your overall return.

So growth is the place to be, right? Actually no. It depends on the time period used. In the first edition of this book, the five-year performance of value was significantly higher than growth over a five-year period ending in December 2006 (value delivered 67.5 percent versus growth’s return or 14.2 percent). At different times, value and growth outperform one another.

Assessing your screening results

After completing your screen, you need to have some kind of ranking system so you can focus on the most promising candidates first and work your way down. You can rank securities by their P/E ratios, for example, from lowest to highest. Or you can rank securities by their return on equity or price to free cash flow ratios. Ranking helps you push the cream to the top.

HGS Investor allows users to create “combo rankings,” which allow ranking based on two or more measures (like 30 percent weight on EPS rank and 70 percent weight on P/E).

When identifying a promising swing trading candidate using a fundamental screen, the right security should jump out at you. You shouldn’t have to do a lot of equivocating or questioning. Here’s how to analyze your results:

• If the security is one you want to buy, verify that it exhibits strong earnings, has a low valuation, and is in a well-performing industry.
• Use volume to weed out weak candidates from strong ones. You want to be buying when volume is confirming the move.
• If you go through your screened results (for example, 100 stocks fit the screening criteria) and you find yourself saying yes to many of them, it’s a sign you aren’t reviewing the results properly. Remember, most securities should be candidates that you may like to buy when X, Y, or Z happens. You should only go on green, meaning the same day a signal is generated.
• Combine your fundamental analysis with events to enhance your results. Review the company’s recent news announcements because they may be positive catalysts for propelling the stock higher. But don’t buy one or two weeks after the news unless the chart is only telling you to go on green at that time. Usually, news gets incorporated quickly into stock prices so buying on news that’s seven days old may prove ill timed.