From the Archives: The Missing Link --Sector Analysis

This week in From the Archives we present Chapter 4 in the Yates Guide to Options Investing (1994): The Missing Link -- Sector Analysis, written by Jim Yates.

When most investors think about portfolio management, they see a two-part problem. First, there's the market itself. Second, there are individual stocks. Portfolio managers know that there's a "missing link" between these two subjects. The missing ingredient is called sector analysis.

A sector is defined as "a distinguishable subdivision." From a stock-market point of view, a sector is a group of stocks in the same general industry. Because economic conditions increasingly affect entire industries, sector analysis has become an important part of portfolio management.

Sector analysis isn't an easy task. The job is similar to that of a portfolio manager in that stock selection is an important consideration. Determining the appropriate sector designation for a stock is not always simple because a company may have operations in several different industries. In addition, a decision must be made as to how many distinguishable subdivisions there are in the market. Finally, there's the problem of comparing the performance of sectors. Wile all of the above is going on, it must be remembered that the purpose is to remain objective in the analysis.


The Zone system of stock market analysis is particularly suited to sector evaluation because it allows the objective measurement of the relative movement of often widely varying groups of stocks.

Our sector analysis divides the market into 20 industry groups. These groups were chosen because we wanted to keep the list to a manageable number, and 20 seemed the logical choice. Each stock in our database is assigned to one of the 20 groups on the basis of its major business activity. The 20 sectors are:

-- Aerospace -- Autos -- Building --Chemical --Consumer
-- Data Processing --Drugs --Electronics --Food --Insurance/Finance
--Integrated Oils --Leisure --Machinery --Metals --Miscellaneous (Conglomerates)
--Non-Integrated Oils --Oil Service --Retail Trade --Transportation --Utilities

The ranking score for each sector is determined by averaging the 90-day Implied Risk readings for all the issues in the group. The Implied Risk reading for each stock represents the percentage deviation of the price of the stock from its 90-day trend, relative to what is expected given the stock's option implied volatility.

A stock with an Implied Risk reading of -100 is at the top of its Implied Risk trading range. When stocks are grouped together as they are in this analysis, there's a dampening effect to the average Implied Risk score. This dampening is called the "portfolio effect," and is due to the fact that stocks in a portfolio -- even those is similar industries -- rarely move at exactly the same time. We adjust for the portfolio effect by reducing the group range from +60 to -60.

We rank the 20 groups, with the group nearest the top of its Implied Risk trading range ranked first. We also list the Implied Risk score for each sector over the past week, month and three months. The objective isn't only to determine the strongest sector in the market, but also to determine the probability of future advances. The recent sector scores are intended to provide trend perspective that allows us to identify groups that are making significant moves relative to the rest of the universe.

The sector score range of +60 to -60 means there are six 20-point divisions, which we call Zones. An industry group with an Implied Risk reading above -40 as reached Zone 6. To get to Zone 1, a group needs to compile an Implied Risk reading below +40. The expectation of occurrences in each Zone is the same as for individual issues. We expect each sector to visit each Zone annually, and we expect them to be in Zone 3 or Zone 4 about two-thirds of the time.

The purpose of this type of analysis is to fill in that gap between market-risk analysis and stock-risk analysis. We believe that market risk represents about 50% of the total risk involved in trading stocks. Stock risk represents another 25% of your total risk. That leaves 25% of the total risk for the sector analysis. Proper sector analysis, we believe, can improve both stock-market analysis and and individual-issue analysis.

In the case of the general market, a close study of the sector can often explain otherwise inexplicable market activity. A rising market may be led by the Integrated Oils, for example. That sends a different message than an advance led by Insurance & Finance. Individual stocks analysis also can be enhanced using sector analysis. For instance, a stock that reaches either extreme (Zone 1 or Zone 6) while its sector is at the opposite end of the spectrum could be experiencing an important fundamental change. The stock that resists sector weakness may signal future strength.

This latter factor is similar to a condition technicians often refer to as relative strength. But this kind of relative strength is different, because it relates individual stock movement to the sector rather than to the overall market. Because sector analysis enhances our understanding of both the overall market and of specific stocks, it deserves the title Missing Link.

This system allows us to measure movement relative to expectations. For instance, technology stocks may experience a larger percentage move than other issues, but that greater movement potential is anticipated and incorporated into the volatility estimates for individual issues in the sector. When we adjust the movement for volatility expectations, we're left with a uniform analysis that permits direct comparison of wildly disparate sectors and issues.