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Sector Analysis & Index Trading
by Chris Verhaegh

Predictions for the Future

You don’t have to be Nostradamus to predict certain events. Anyone using a little brainpower might come to these same conclusions to make specific forecasts about stocks and markets.

First prediction: No index will go to zero. Lots of stocks will fall by the wayside, but not a single index will completely evaporate. Some may no longer be measured, but none will disappear in principal.

Ramification of prediction: No matter how ugly it may appear, an absolute bottom exits for indices (plural of index). And it’s not zero!

If someone were to invent a car that could run on water, do not expect the oil indices to go to zero. Just because we wouldn’t need oil to make gasoline for all these new cars, we would still need oil to make fuel for all old cars. Additionally, plastics are based on petroleum.

Second prediction: Time spent analyzing sectors or indices will be profitable. This second prediction could be construed as pandering, yet let’s explore sector/index analysis.

Sectors are groups of stocks in similar subsets of the market or economy. S&P breaks the market into 11 sectors: basic materials, capital goods, communications services, consumer cyclicals, consumer staples, financial energy, health care, technology, transportation, and utilities.

Indices are more complex. Some indices are broken down by market cap range and not by common industry. Examples: small cap, mid cap, and large cap. Companies can change indices because their price moves. They won’t move sectors.

Moreover, since originating as measuring tools and benchmarks, various indices are weighted differently. Some are price weighted (DOW 30), capital weighted (S&P 500), modified-capital weighted (NASDAQ 100). Also, equal dollar weighted or modified equal dollar weighted indices exist. That means the same stock in multiple indices might have varying effects.

Microsoft is a part of numerous indices, including the Dow, the S&P 500, and the Nasdaq 100. When it moves, it affects each of these indices in different amounts and/or percentages.

Trading the Baskets

Futures exchanges, such as the Chicago Mercantile Exchange (The “Merc”), trade futures contracts on some indices. Traders can go Long or Short with large amounts of leverage. Unlike options, which have a fixed amount of risk, Futures Contracts leverage by requiring only a small initial deposit against a potentially massive amount of risk.

Some indices only represent a statistical number. They measure how hot or cold a sector or industry is doing. They cannot be bought or sold. Sort of a thermometer.

Most every index is a product of some company or exchange. Many of these exchanges don’t trade futures or stocks, they only trade options. Hence, some indices can’t be traded, but cash settling options on them can. Think of these options like betting on the weather. Higher prices are hot, lower prices are cooler. Calls are bets on heat. Puts are bets on cold.

Still other indices have evolved to become tradable investment vehicles. Various tracking shares, revolving around different sectors and/or indices, have sprouted up. These trade similar to stocks, but their analysis maybe more complex. Additionally, indices can be compared against the stocks making them up.

If a trader feels a particular company will outperform its index, they might go long the stock and short the index. Profits can come if both go up or if both go down, as long as their forecast is accurate.

For example, a trader believes Microsoft will do better than the market. This trader can put his money where his mind is by buying Microsoft and selling the index. But which index? Microsoft is in all three broad based indices.

This buying of one issue and the selling of another is known as “pairs trading”. It isn’t limited to index trading. If you believe Coke will outperform Pepsi, you can buy Coke and sell Pepsi. The problem lies in the fact that it can tie up large sums of money and is best left for deeper pockets.

Someone with less funding may use this to analyze stocks for better entry and exits points. Since many stocks make up an index, you can compare each to the others or to the index as a whole.

Charting software allows relative value charting. Starting two or more issues at 0% on a given date and charting their performance as a percentage gains/loses from there.

Assume a trader lives in Idaho and wants to trade Boise Cascade (BCC) because they feel comfortable with the company. They can analyze everything about BCC, including how it compares to others in its sector, International Paper (IP), Georgia Pacific (GP) and Kimberly Clark (KMB) to name a few.

By running relative value charts, the trader might see that one company historically lags behind the others. This trader then might choose to trade his company, if and when the others move, anticipating the laggard to follow.

You should be wondering, what makes anyone think this company will catch up? Good question, logical answer; Pairs traders and fund managers.

Pairs traders look for imbalances and look to profit from their rebalancing. Mutual fund managers manage. They typically buy stocks to fill allocations. If their diversity model says they should have $X amount in the forest & paper products sector, they look to outperform their benchmark; the forest & paper product index. They look for value. What can be more under-priced than the boat that hasn’t lifted the tide yet?

Be aware, this works best in well established industries with companies on somewhat equal footing. The price of a barrel of oil affects Shell, Chevron-Texaco, Exxon-Mobil and all other oil conglomerates roughly the same.

You must understand, there can be concerns with individual issues and no one should just trade with relative value charts, but it is a good place to find opportunities.

This allocation concept can be carried down to individual investors as well. Assume an investor has their net worth stored in their company 401K plan. Also assume they can only have their 401K plan in one of the four locations; cash, company stock, S&P 500 mutual fund, Nasdaq 100 fund.

Assume they can only profit from price increases. No shorting or using Put options to protect against downward market pressure. Their only safety valve is the cash alternative.

Continue the assumption with the understanding they can only change their positions once a day, at the close. But also assume there are no transaction costs.

By analyzing all of the alternatives, the choices are endless. This investor can allocate in any percentage breakdown they see fit. If they feel the market is due for major correction, they allocate 100% to cash. If they see the high-tech Nasdaq as outperforming the S&P, they over allocate in to it.

At the end of a year, or better still the end of a career, their 401K should be considerably higher than one that just bought and held.

 
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