Individual stocks do not exist in a bubble. Every publically traded stock is part of a larger financial sector. Here are some examples of market sectors and the companies that belong to them:
- Automotive – Toyota Motor Corp (TM), Harley-Davidson Inc. (HOG)
- Financial services – Wells Fargo & Co. (WFC), Citigroup Inc. (C)
- Health care – Johnson & Johnson (JNJ), Pfizer Inc. (PFE)
- Aerospace/defense – Northrop Grumman Corp (NOC), Lockheed Martin Corporation (LMT)
- Retail services – Tractor Supply (TSCO), Staples Inc. (SPLS)
- Internet – Google Inc. (GOOG), LinkedIn Corp (LNKD)
As a general rule, you can expect all of the stocks within the same sector to perform roughly the same [source: Abraham]. There are exceptions to this rule, of course, especially in the short term. If Nokia reports more smartphone sales than Apple, you might see a momentary bump in Nokia stock and a drop in Apple. But if you look at the bigger picture, you can expect both Nokia and Apple to follow the long-term trends in the consumer electronics sector.
How does sector analysis help you guess when a stock has hit its bottom and is about to rebound? If an individual stock generally tracks the performance of its sector — at least in the long term — then you can compare the performance of the stock to its sector to predict future price movements.
As a hypothetical example, let's say that Yum! Brands — which owns Pizza Hut, Taco Bell and KFC — saw its stock price drop 5 percent over the past year. In the same time period, however, the entire "leisure services" sector has grown 10 percent. Unless Yum! Brands is having some serious problems — major lawsuit, CEO in prison, employee strike — we can reasonably expect it to ride the trend of the rest of the sector.
What does that mean? It means that even though Yum! Brands is down, it's probably not down for long. In fact, a rebound might be on the horizon.