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Ask The Analyst, Sunday, 03/28/2004

Breaking down .... the Dow Industrials
By Jeff Bailey

This week we saw further deterioration in the various major market bullish % indicators, and this has my e-mail full of various questions regarding what stocks may be viable put or short candidates, as well as questions on how far we might begin looking for the major markets to decline.

In order to try and answer several questions with one article, we'll start with "what we know" and work from their.

In the OptionInvestor.net Index Trader Wrap from 03/22/04, we took a look at the Dow Industrials (INDU) 10,212.97 point and figure chart, and this weekend, I'm going to use the Dow Industrials as an example of how a trader/investor can begin what may be an important exercise in assessing downside risk, where we begin to see more internal damage taking place in the various bullish percent indicators.

I've chosen the Dow Industrials as my example index, as it is a rather simple index to keep track of, with just 30 stocks comprising this major market average.

Let's first start with "what we know" or some preliminary technicals, where for the first time since this great bull market took hold in March of 2003, the Dow Industrials has done something it hasn't done since March of 2003, where we have seen two consecutive point and figure sell signals. This is DIVERGENCE from the past, and should have traders and investors taking a more defensive approach to investing or trading in their investment accounts.

Dow Industrials (INDU) - 50-point box scale

I've marked a few details on the INDU's point and figure chart, where the BOLD RED CIRCLES at 10,400 and 10,050 mark two consecutive point and figure sell signals. Those traders/investors that would like to view a point and figure chart can do so for FREE at www.stockcharts.com.

There are TWO basic DOWNSIDE RISK assessments that traders and investors may be making at this point. ONE downside risk assessment is the current bearish vertical count of 9,400, which was generated by the long column of Os from 10,700 to 10,100. While bearish vertical counts can be exceeded, but sometimes never met, a bearish vertical count is a good starting point to begin assessing downside risk.

Since bearish counts are sometimes never achieved, a SECOND downside risk assessment can be made to the INDU's rising bullish support trend (BLUE +), where should the INDU's point and figure chart see a 3-box reversal, with a trade at 10,100, would have the bullish support trend at 9,700.

It would be inaccurate to assume that a Dow Industrials decline to 9,700, or 9,400 could then be translated to either similar percentage declines in the S&P 100 (OEX.X), S&P 500 Index (SPX.X), or the more volatile and tech-heavy NASDAQ-100 Index (NDX.X), but one could begin to sense that a Dow Industrials decline to either the 9,700 level or 9,400 level would most likely find other major market averages seeing a decline.

Again... the INDU is a good index to begin breaking down, as a trader/investor can more easily comprehend and review 30 point and figure charts, than they can 100 charts (OEX and NDX) or 500 charts (SPX).

Once a trader/investor has started assessing downside risk, with potential lower levels of trade and the bearish vertical count, they can also begin to understand RISK, along with internal strength or weakness as depicted by the Dow Industrials Bullish % ($BPINDU).

Before we move on, traders and investors should understand that the Dow Industrials is a very general representation of the U.S. markets, but 30 stocks can by no means be a full representation of an overall market containing more than 10,000 stocks listed on the three major exchanges here in the U.S.

With that said, the INDU still gives us a very simplistic, or easy way of beginning to grasp what has taken place, and what we can begin looking, or monitoring for, in the future.

Dow Industrials Bullish % ($BPINDU) - 2% box scale

Some traders/investors had questions regarding the bullish % indicators, and one of the most simplistic ways to understand the 6 market stages, which the bullish % charts hopes to describe, is to think of a roller coaster ride. Lets begin with the with the March 2003 lows, where in BROWN, I've marked an entry at the beginning of March (RED 3 on a point and figure chart) where the Dow Industrials Bullish % had fallen to roughly 12%, which meant that of the 30 Dow components, only 4 stocks had their point and figure charts still showing a buy signal associated with the chart. In early March, the INDU Bullish % reversed up from "bear confirmed" status to "bull alert" status at 16%. As time passed, we see the INDU bullish % rising further, as more and more stocks began generating point and figure buy signals, as demand (X) began outstripping supply (O). By mid-May (after RED 5) the INDU Bullish % achieved "bull confirmed" status at roughly 52%, when 16 of the 30 Dow components' point and figure charts were showing point and figure buy signals. As demand (X) really started to outstrip supply, the INDU Bullish % continued to rise as more and more stocks were generating point and figure buy signals.

Despite the extremely high levels of RISK (levels above 70% are deemed higher levels of bullish risk) the INDU bullish % went through several gyrations when reversing to "bull correction", then back up to "bull confirmed," then back down to "bull correction," then back up to "bull confirmed," then back down to "bull correction," and just recently we observe DIVERGENCE, or a CHANGE, when the INDU Bullish % now reads "bear confirmed," and at a high level of BULLISH RISK.

I circles all six phases from "bear confirmed" to "bull confirmed" on the INDU Bullish % chart, where trader/investors can begin to see, feel, and understand the 6 stages of market condition, while also observing time intervals between the stages, which can be quick, and sometimes long-lasting.

Stock market analysis can be complex when we begin trying to analyze all the reasons "why" bullishness or bearishness is occurring. However, a trader/investor, maybe Rip Van Winkle, who has been asleep for sometime and wasn't aware of what geopolitical events, or economic cycles have been experienced, could probably look at a bullish % chart, and begin to understand how a market will rise as demand outstrips supply, and how a market will decline as supply overtakes demand.

A very simplistic approach to these cycles is the belief that a market accurately anticipates good news as stocks rise, and once a markets value is deemed appropriate, or excessive, then supply from selling and profit taking sets in, and markets then fall to an appropriate value for whatever reason, which is usually fully realized at a bottom.

Traders and investors that have been monitoring the markets the past three months have seen the markets rise in January, but then begin declining in February and March.

Is something wrong? Does the MARKET know something about the future that is yet to be revealed? Or are market participants just looking to take profits, and systematically begin removing BULLISH RISK after a massive amount of gains have been accumulated in the past year?

Let's begin to look at the some of the Dow 30 components, and begin to try and comprehend what has taken place. Here we will try and truly get a "feel" for what has started to take place, but in chronological order.

Since the INDU Bullish % ($BPINDU) has reversed lower to "bear confirmed" status after signaling bullishness since March of 2003, I will be focusing more on the BEARISH activity that has taken place, which has the INDU Bullish % reversing into its "bear confirmed" market condition.

Dow Industrials Table - 03/26/04 Close

What I've done with the above table, is sorted at the top, the 7 Dow components, that currently have a point and figure sell signal associated with their supply/demand chart. AT&T (NYSE:T) $19.99, gave a reversing lower point and figure sell signal back in October of 2003, and since that time, has not been able to generate a reversing higher point and figure buy signal.

Since we are really trying to focus on what has been taking place the past couple of months, I really wanted traders/investors to begin to feel, and observe what is taking place, when Caterpillar (NYSE:CAT), Intel (NASDAQ:INTC) and United Technologies (NYSE:UTX) generated sell signals.

Before we do this, I want to explain some things in the above table.

I've listed the bearish vertical counts (COLUMN E) of the 7 stocks that have generated point and figure sell signals. Those in BLUE are bearish vertical counts that are currently under construction, where a 3-box reversal back higher, would then have the bearish vertical count fully constructed. Please note that United Technologies (NYSE:UTX) has already exceeded its bearish vertical count of $88.

One thing I learned recently, is that for every $1 decline in a Dow component (the INDU is PRICE weighted) that $1 decline equates to roughly 7 Dow points (7.4100 to be exact). At the bottom of the table, I totaled all of the Dow components' closing prices, multiplied by 7.41, which equals 10,214.24, and very close to Friday's close of 10,212.97.

What this information can allow us to do, is begin to understand the potential downside implications of the 6 stocks (exclude UTX for now) to their currently calculated bearish vertical counts, should they be achieved. In COLUMN F, I subtracted current price (COLUMN D) from the bearish count (COLUMN E) and multiplied by 7.41 to get a sense for what impact these 6 stocks alone may have on the INDU. In COLUMN F:ROW 11, these bearish vertical counts, if achieved would have negative impact of 386.14 Dow points.

We should understand that a 386.14 decline assumes the remaining 23 components, along with UTX, which already exceeded its bearish vertical count, remained unchanged. Still, with this observation alone, we can begin to sense, observe some potential downside, in a "bear confirmed" market environment.

I also tabulated those Dow components bullish vertical counts, where point and figure buy signals are still associated with the supply/demand charts (ROWS 12-34: COLUMN G) and when subtracting COLUMN D from COLUMN G and multiplying by the scale factor of 7.41, can tabulate potential BULLISH implications of those stocks that have not yet achieved their current bullish vertical counts, which remain in play, until a negating point and figure sell signal is generated.

Here we can begin to once again utilize the INDU Bullish % ($BPINDU) and begin to understand that there is probably a high probability at this point, as the bullish % begins to decline from a high level of BULLISH RISK, that we will most likely see more stocks generating point and figure sell signals.

For ROWS 12-34 : COLUMN B, I placed the price level where those stock still showing a point and figure BUY signal associated with the chart, would generate a SELL signal on the respective stock's supply/demand chart. Those stock in ROWS 12-34 were then sorted as to which stocks were CLOSEST to FURTHEST from generating a reversing point and figure sell signal, as of 03/26/04 close.

In a "bear alert" or "bear confirmed" market environment, assessing DOWNSIDE RISK to a point and figure sell signal is essential for a trader/investor that may be LONG/BULLISH a stock, where no bearish vertical count is available.

Let's now take a look at Caterpillar (CAT), Intel (INTC) and United Technologies (UTX) and make some chronological observations of how market internals can weaken, where a trader, especially a bearish trader, begins to try and uncover trading opportunities for shorting stocks, when using some recent deterioration, to then carry over to other trading opportunities.

Caterpillar (CAT) - $1 box scale

Caterpillar (CAT) is perhaps an excellent stock to tie in with the INDU Bullish % ($BPINDU) when trying to grasp the concept of the various phases of a market cycle, while also making some observations as to how the bullish % can depict a HIGH level of BULLISH risk, and LOW level of bullish risk.

Beginning in the lower left corner, CAT gave a triple top buy signal at $48, and was perhaps one of the first stocks to generate a buy signal, which helped the INDU Bullish % reverse up to "bull alert" status. BULLISH RISK was LOW, and the stock was saying "buy me." CAT's bullish vertical count column hinted at a bullish target of $69, even though the U.S. was at war with Iraq.

As you can see, CAT achieved its bullish vertical count of $69, before it generated a "sell signal" at $68, when in September (after RED 9) the INDU Bullish % was in "bull correction" status.

The more extreme amounts of bullishness may have had CAT generating a reversing upward point and figure buy signal, and once again establishing a bullish vertical count of $99.

However, on January 28, 2003, CAT generated a reversing lower point and figure sell signal, which negated the bullish vertical count. Is something wrong with CAT? Or has BULLISH RISK simply become too HIGH, and the market is removing that BULLISH RISK in the form of profit taking, where supply (O) has began to outstrip supply?

We could assume either, but history suggests that BULLISH RISK is currently being removed, and could continue to the current bearish vertical count of $66.00.

Traders/investors can study the point and figure chart of CAT, and begin to understand how a stock will decline to a point, then rally, then decline, and begin to say to themselves, "if I had sold at a certain price level, then this was the eventual outcome.

For those that have a FREE trial with www.dorseywright.com or have a subscription to their point and figure charting site, CAT is classified as belonging to the "Machinery and Tools" Bullish % (BPMACH), which similar to the INDU Bullish % is currently in "bear confirmed" status at 66%. One begins to associate some MARKET and SECTOR weakness at a high level of BULLISH RISK.

Intel (INTC) - $0.50 & $1.00 box scale

Intel (INTC) has been the 3rd most recent Dow Component (behind T and CAT) to generate a reversing lower point and figure sell signal. Here too we see in March of 2003, INTC generated a point and figure buy signal, constructed a bullish vertical count that hinted at $27.50, and being one of the earlier stocks to generate a reversing higher buy signal, it too achieved and exceeded its bullish vertical count. On February 23, 2004, INTC has exhibited its first sign of meaningful weakness when it generated a double bottom sell signal at $29.

According to www.dorseywright.com, they classify INTC as belonging to the Semiconductor Bullish % (BPSEMI), which is currently "bear confirmed" status at 36%.

Here we can make a rather important observation as it relates to BULLISH RISK, as well as sector weakness when comparing the Machinery and Tools group to the Semiconductors group. There is GREATER WEAKNESS in the Semiconductors, but there may be a HIGHER DEGREE of BULLISH RISK still to be found in the Machinery and Tools group.

United Technologies (UTX) - $1 box scale

Once again traders/investors can begin to see great similarity in the supply/demand chart of UTX with those we looked at above. UTX is perhaps more similar to that of CAT than INTC, but observations as to the INDU Bullish % ($BPINDU) at HIGH LEVELS of BULLISH RISK, and the earlier weakness in UTX, as well as the lower lows and lower high distribution pattern become somewhat obvious.

Stockcharts.com has calculated what I call a "secondary bearish vertical count," which point and figure chartists will sometime calculate if a stock achieves and exceeds its initial bearish vertical count. This is often done in the EARLY stages of a bullish % reversal, when there may still be a HIGH LEVEL OF BULLISH RISK still found in a market, where as that risk is removed in the form of lower price, that pickup of broader selling can have stocks that have lead the decline, falling further, as most market participants become less willing to step in front of the broader market decline, instead looking for a sign of strength to then begin bullish buying.

Dorsey/Wright and Associates classifies UTX as belonging to its Aerospace Airline Bullish % (BPAERO) which is currently "bear alert" status at 52% and after reversing straight up from a very oversold level of 20% in March of 2003, would currently take a reading of 18% to achieve "bear confirmed" status.

This is just a starting point, but begins to lay some groundwork for traders and investors to build on.

Again.... you can view FREE point and figure charts at www.stockcharts.com, or try a 2 week FREE trial subscription at www.dorseywright.com.

I don't have enough time to review all of the Dow components in this article, but traders and investors can begin studying other charts, make some ties with the various market bullish % indicators, to get a better feel for the markets.

Jeff Bailey

 

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