Guilty by Association

Story Highlights:

• Individual stocks are most often correlated with respective sectors, regions, and like-valued companies
• Thus, understanding the broader market view is imperative to successful investing
• A contemporary example is Capital Markets stocks, which are moving as a group based on the results of a few companies

Owning the stock of a great company isn't enough by a long shot. Investors must know more.

A core MarketMinder principle holds that stock selection for portfolios should be a "top-down" process. This means first one makes macro-decisions about market direction, then moves on to country, style, size, and sector considerations. Only after all that's done can we decide upon which stocks to own.

Why? Stock performance and company performance are two distinct things, and don't always align. You might hold stock in the best company in the world but it still may not perform all that well. That's because in the short- and medium-term stocks are beholden to all sorts of factors outside pure company performance, including sentiment, macroeconomic factors, politics, and related companies.

Thus, stocks in specific categories tend to have meaningful positive correlations. For instance, stocks in Japan are correlated, as are Energy stocks, small cap stocks, and so on. So, instead of just saying "I want to find a good Technology stock," you've got to decide if stocks in general are going to go up, and if so, will Technology stocks outperform the market, and if so, in which country and valuation level, before even thinking about an individual Tech stock to buy.

(Editor's Note: MarketMinder does NOT recommend individual securities; the below are simply examples of a broader theme we wish to highlight.)

A great contemporary example is the Capital Markets industry. At one point today US Capital Markets stocks were down in excess of 3% and have been pounded all week. While it's true some companies are taking hits tied to asset write-downs, the only one who reported anything meaningful today was Merrill Lynch. Merrill said it engaged in off balance transactions to hide devaluating assets. It is currently anticipated Merrill will write down an additional 4-5 billion. (However, Deutsche Bank published a report today saying Merrill could write down an additional $10b in assets.)

On this report, Merrill sank a whole category of companies. They didn't do anything themselves; they're just guilty by association. Investors must understand their portfolios from a "top-down" perspective instead of just considering stocks in a vacuum.

We might say the same for Consumer Discretionary stocks today, many of which are reporting good results this year. Yet, because of a few bad apples and dour sentiment in general, just about everyone's getting punished. This reminds us of the big drug makers a few years back, which all sank by proxy as Merck dealt with the famous Vioxx lawsuits.

These are just examples (not recommendations) of why the top down approach is key when making a forecast for stocks in the short- and mid-term. On that note, however, we reiterate our bullishness for stocks in general—the top most decision in the top-down process. Some stocks go down, others up, but on balance they continue to move higher this year, and that's the most important feature of all.

Have a great weekend.