Sector and Industry Analysis: A William O'Neil Approach to Finding Market-Leading Stocks

William O'Neil's CAN SLIM system is a effective tool for identifying individual growth stocks. However, O'Neil also emphasized the importance of sector and industry analysis. He understood that a rising tide lifts all boats, and that the majority of leading stocks come from leading industry groups. For the experienced trader, incorporating a top-down approach that starts with sector and industry analysis can significantly improve stock selection and timing.

The Power of Industry Groups

O'Neil's research showed that 37% of a stock's move is due to the industry group it's in, and 12% is due to the sector. That means that nearly half of a stock's performance is determined by its industry and sector. This is a effective statistic that highlights the importance of fishing in the right pond. You can be a great stock picker, but if you are fishing in a weak industry group, your results will be mediocre at best.

The strongest stocks tend to be in the strongest industry groups. These are the groups that are benefiting from a major new trend or innovation. For example, in the late 1990s, the internet was the dominant new trend, and the leading stocks were all in the internet-related industry groups. In the 2020s, trends like artificial intelligence, electric vehicles, and biotechnology have produced a new crop of market leaders.

Identifying Leading Industry Groups

So, how do you identify the leading industry groups? The first step is to look at the price performance of the various industry groups. Most financial data providers offer tools to track the performance of different industry groups. Look for groups that are outperforming the overall market and are showing strong upward momentum.

In addition to price performance, you should also look for industry groups that have a large number of stocks making new highs. This is a sign of broad strength within the group. A group that has only one or two stocks making new highs is not as strong as a group that has a dozen or more.

Another clue is to look for industry groups that are being mentioned in the financial press. When a new trend is emerging, you will start to see more and more articles and reports about it. This can be an early indication that a new leadership group is emerging.

The Role of the Overall Market

It is also important to consider the direction of the overall market. O'Neil was a strong believer in the importance of market timing. He found that three out of four stocks will follow the direction of the overall market. This means that even the best stocks in the strongest industry groups will struggle to make headway in a bear market.

The best time to be buying growth stocks is when the market is in a confirmed uptrend. A confirmed uptrend is when a major market index, such as the S&P 500 or the Nasdaq Composite, breaks out to a new high after a period of consolidation. This is a sign that the bulls are in control and that the path of least resistance is to the upside.

A Top-Down Approach to Stock Selection

By combining sector and industry analysis with the CAN SLIM system, you can create a effective top-down approach to stock selection. The process looks like this:

1. Identify the trend of the overall market. Are we in a confirmed uptrend or a bear market? If the market is in a downtrend, it is best to be in cash.
2. Identify the leading industry groups. Look for groups that are outperforming the market and have a large number of stocks making new highs.
3. Identify the leading stocks within those groups. Use the CAN SLIM criteria to find the best of the best. Look for stocks with strong earnings growth, high relative strength, and a sound chart pattern.

By following this top-down approach, you can increase your odds of success by focusing on the strongest stocks in the strongest industry groups in a rising market. This is the recipe for capturing explosive gains in growth stocks.

Real-World Example: The Software Group in 2019

Let's look at the software industry group in 2019. The overall market was in a confirmed uptrend for most of the year. The software group was one of the leading industry groups, with many stocks breaking out to new highs. Within this group, stocks like Shopify (SHOP), Twilio (TWLO), and Okta (OKTA) were all exhibiting classic CAN SLIM characteristics.

Traders who followed a top-down approach would have first identified the uptrend in the overall market. They would have then identified the software group as a leading industry group. Finally, they would have used the CAN SLIM criteria to pinpoint the leading stocks within that group. This approach would have led them to some of the biggest winners of the year.

By incorporating sector and industry analysis into your trading routine, you can gain a significant edge in the market. It is a effective way to focus your efforts on the most promising opportunities and to avoid the pitfalls of a weak market or a lagging industry group.