Top Down or Bottom Up?

Top Down or Bottom Up?

This is a philosophical question every investor has to ask themselves: Do you take a Top Down approach to your market analysis or a Bottom Up? Depending on the answer, you may have very different views of the market. Currently a Top Down view would be considering that while the markets are in uptrends, they are extended and due for a correction. Your view would be cautiously optimistic. If you use a Bottom Up method, you are likely finding many interesting individual stocks that fit your risk parameters. Lets take a look at what I mean with examples of both methods.

Top Down 

The broad markets have rallied strongly for several years and especially over the short term we may be seeing the early stages of a decent pullback.

The longer a trend is in place the more concern you begin to hear from overeager participants. A hint to studying trend is to attempt to identify where you currently are in the total move. One way to do that is to watch for the slope of the uptrend to change. As the slope increases, the sustainability of the trend begins to degrade and caution is warranted. Here you can see that while the trend is certainly higher over the last 5 years, the slope of the trend has continued to steepen over time. The steeper it gets, the more likely a reversion to the mean becomes. Ultimately there isn't a good way of timing when a move like this will end, but as it continues to increase in slope, the risk of capital loss increases as well.

Taking a closer look at this view, price is testing the upper channel resistance area on the Daily chart.

Each time that prices have rallied into the upper boundary here we have seen multi-week consolidation activity, both through time and price. This current setup suggests the market is extended and needs a breather. Roughly 4 out of 5 stocks trade in sympathy with the general market, therefore if a correction in the market comes, it will likely affect most of your open positions.

Again, from a Top Down standpoint the trends are still pointing higher longer-term, but shorter-term things look less than optimal. The leading sectors for the year so far are Utilities, Healthcare and Energy, while Discretionary, Industrials and Financials are the weakest. Typically in strong markets these performers are usually flipped. If you are a Top Down investor it would likely be a good time to be reducing exposure at these levels.

Bottom Up 

Or should I say "Bottom's Up!", because some people think you would have to be dumb, drunk or both to be buying stocks at current levels. If 4 out of 5 stocks will trade lower when the market trades lower, why take extra risks here? Why not just hunker down and wait for the next correction? My answer to that is, if you have been waiting for a correction to put money to work, you have been waiting for over two years now and have missed one of the best investment opportunities of your lifetime (if you are an old guy/gal). You would have been worrying about the market being extended for a few years, yet it continues to grind its way higher.

If you had a Bottom Up approach you no doubt have found ample low risk setups over the past few years and have likely made a good deal of money doing it. While the noise in the media and economy has been deafening (it always is though), you would have been mindlessly adding to strong trending positions and taking new entry signals as your system generates them. You would have been seeking out strong performing companies with continually improving stock prices and charts.

While I showed the scary look of the broad market in the Top Down section, even this week with the SP500 down nearly 1%, we have two new signals for our blog portfolio to take and the setups are very solid in terms of risk/reward. Here is what our Bottom Up approach came up with this week:

Entering Time Warner (TWX)

After rallying strongly for the better part of 2 years, TWX has spent the last 8 months moving sideways, consolidating those gains. Recently price has been bumping against this upper resistance boundary near $71, this week we decisively broke through. The risk is very nicely defined here as the prior swing low at $67.50 can act as our stop. A failure of that low would suggest the breakout has failed and more consolidation is needed. For longer-term investors, you could use the lows at $62.50 as a wider stop. Either way this sets up nicely. Now take a look at the long term picture here for some added risk/reward perspective.

While the rally over the past 2 years has been "too far too fast" for many, a little added perspective here shows that prices are still well below the mania levels of 1999. The near term rally paused as soon as it made a higher recovery high back in mid 2013 and has since traded sideways using the prior high level as support. Now we are seeing lift off above all those highs and it appears the rally will continue. It may never get back to those lofty valuations of the dot com bubble, but even it it gets half way there we could easily double our money. When I can risk $6 for a potential reward of $70+, I get a little bit excited.

Again a move below $65 and especially $62 would negate this thesis and we would want to await further direction before proceeding.

Entering International Paper (IP)

I have been watching IP for what feels like years now. This thing has traded perfectly sideways for over 18 months. The most maddening thing is that it has done this while the broad market has been repeatedly making new highs. As you can see from the Relative trend, IP has been underperforming for nearly all of 2013 and thus far in 2014. However the last two weeks have shown that maybe the rotation is finding its way to this once loved stock. We saw a breakout of price last week but the Relative Strength hadn't confirmed the breakout until this week's action. I would now expect the uptrend to resume following this move to new highs as well as the recent shift in investor funds into the stock. Initial stops can be placed below the rising 20 WMA which would also coincide with a failed breakout signal. Below the breakout and especially below $46.50 I would want to be very cautious of this area, but above this breakout level, the sky's the limit.


It's not that one method of analysis is right and the other is wrong. These methods simply appeal to different individual mindsets and they both have their place in any investment style. I will say however that on the whole, Bottom Up investors have the much stronger track record than someone who simply focuses on the macro view of the market and economy. Legendary investors like Warren Buffett and Peter Lynch utilize a Bottom Up approach where they believe that buying the strong companies is more important than guessing what the overall economy and market will do. This is where Relative Strength investing really separates itself from the other strategies in my opinion. The very idea of relative strength is that the individual stock will perform better than the overall market. So if you have a stock that is beating the market (we have lots!), then why would you sell that stock when the overall market got weakened? Isn't the reason you are in the stock is because its performing better than the market? If it continues to do so, we need to give it the benefit of the doubt. Its strong for a reason and until its not, we want to stick with it.

When things finally turn bad out there we will be stopped out of our holdings, it will happen at some point. But instead of worrying about when that will be, just wait for your individual stocks tell you so.

It's Tough to Sell

Everyone has a way of buying into a stock; they have a tip, or some inside information on the company, or the stock just made a new high, etc. It's really easy to buy a stock. You just pick the one you want and usually you can find a reason to justify the purchase. The hard part is, when do we sell it? Because thats really the defining point of the trade; the sell point determines how much you made or lost on the initial purchase. While there is no right or wrong way to sell a stock exactly, there are simply ways of reducing risk when certain criteria are achieved. Also just because the criteria is present doesn't mean you will be absolutely correct on your timing. Take our current TLT position for example. Last week we received a warning signal from our Relative Strength trend indicator that suggested that the risk of a sell-off in bonds was now a higher likelihood than previously thought. Now looking back on this week's trading it would appear that the signal for caution was false, mostly.

Prices for Bonds rallied strongly this week, as well as the Relative trend vs. stocks. But I don't think this signal has been proven completely false yet. The price action still shows a lower swing high compared to the  recent peak a few weeks ago. The Relative Strength also shows a rally back to retest the underside of the broken support. What it will take to prove our exit signal false would be to see that RS trend continue back through the trend line to regain the uptrend AND for price to breakout and close above the prior swing highs around $114.50. A move above that and I would be inclined to dramatically increase my TLT exposure again. But short of that scenario occurring, right now its a wait and watch situation. I will continue to hold a half position until price and trend verify that the rally is over. A trade through $110 is still that key level.

The main takeaway is that being able to sell at the exact peak is very unlikely and should not be attempted without valid exit signals. You will not always be right. In fact sometimes you will end up selling at the exact lows and then will have to watch the stock move right back in the prior direction. Look at CMI as a perfect example of this.

There was a clear sell signal in early 2014 when the stock sliced through the 20 WMA and the prior support lows. There also was a clear violation of the RS trend support. We stuck to our plan and reduced risk when the signals suggested it, but within 3 weeks we had received a new buy signal; we added right back when the signals changed higher for the better. The ongoing result should be obvious by simply looking at the chart, price has continued higher steadily.

Some signals will be false, that's just part of the deal. Our job does not require us to guess which signals will work out and which won't. But we are required to take each signal without question because the system picks winners over the long-term. Our success is dependant on those few signals that turn into massive winners, those big wins pay for the many small fake-outs the market sends our way.

Once you find a way to determine when risk becomes elevated you need to act consistently and decisively. If for some reason your signal was wrong, simply adjust right back with the changing conditions. But when your signal is right, it will be really right. As famous investor George Soros once said, "its not about being right or wrong. It's about how much you make when you are right and how little you lose when you are wrong."

This is what sets apart the winners from the losers. Winners make a lot when their signals are right and only lose a minimal amount when they are wrong. Losers do the exact opposite, they lose big and win small.

I'm not sure about you, but I'm here to win.