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Red-lining the Dow Industrials

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Often times it is tough to try and decide or sort through thousands of stocks looking for the right investment/trade. One way to begin looking for a trade is to start with the 30 Dow Industrials components and monitor their progress. Below is a list of the 30 Dow Industrial Components, but this time we're going to imagine that there was real money put to risk on Monday, September 10, 2001, just before the recent terrorists attacks. We're using the "portfolio" function in q-charts and have taken a hypothetical $30,000 (ended up 29,396 due to rounding of shares) and bought roughly $1,000 of each Dow component at the close of trading on September 10th.

What this allows us to do is actually try and measure the MARKETS thinking regarding the various stocks in the Dow. I've sorted the stocks by % gain or loss and we can begin building some scenarios based off our observations.

The trader that only trades bullish (IRA account) is perhaps dividing the Dow into two parts (our red line) with the top 15 performing stocks since the terrorist attacks. As you can see, there are just three stocks that are currently trading higher than their September 10th close. We'll note that two are telecom related (AT&T and SBC Communications) and one discount retailer (Wal-Mart). These are simplistic observations, but may become the building blocks for determining some trends that we can begin researching based on sector/group analysis. The trader that likes to short/put stocks is also making these observations and perhaps avoiding short/put plays in some telecom stocks, but focusing his/her efforts on those stocks and like sectors that are in the upper end of the lower half or near our red line.

Dow 30 - $1,000 invested in each at close of Sept. 10

In last night's market wrap on premierinvestor.net we made some of the same observations in SBC Communications (NYSE:SBC) and AT&T (NYSE:T), but also had some questions regarding shares of Caterpillar (NYSE:CAT). The question posed at the time was "What the heck is CAT doing in the number 6 position of Dow performers since Sept. 10th?" Our thinking was that the economy is supposed to be slowing, but shares of CAT had been hanging tough. Today we see that CAT has slipped to the number 10 slot and perhaps some other market participants were wondering the same thing last night.

What we're doing above and how all subscribers can be using a similar approach (everyone should be doing this with their own investments and portfolios, even if done on a sheet of paper once a week or once a month) is monitoring relative strength from a benchmark. In the above example, we're benchmarking to a particular date (Sept. 10th) before a market moving event.

Four stages of relative strength

There are basically four stages of relative strength. I've defined these four stages based on the point and figure charting technique of relative strength. Many investors/traders are more familiar with the line graph of relative strength, but that type of measurement is more difficult to perhaps make any type of buy/sell decision with. The point and figure system gives us some guidance as it relates to a buy signal or sell signal with relative strength and helps us determine what type of "stage" the particular stock/sector is in relative to the broader market or index we're measuring against. Let's try and build upon SBC Communication's (SBC) success and see what its relative strength was and is telling us about this stock vs. the S&P 500. Then try and take that a step further to identify other potential winners.

Relative Strength of SBC vs. S&P 500

Understanding the various 4 stages of relative strength are perhaps better understood as I've colored them above. "Stage 1" is when a stock begins to perform well or firm up vs. a broader market average. Then as confidence or more knowledge is gained regarding the stock, "Stage 2" develops and a "relative strength buy signal" occurs. This is often times when the stock really begins performing and distancing itself from the pack. We all know that stocks don't just keep going higher and eventually profit taking comes into play and "Stage 3" develops. This is the most opportune time to either take profits, write covered calls or hedge a bullish position. When profit taking becomes stop loss selling and buyers are hard to come by is when "Stage 4" develops and a relative strength sell signal is generated. This is often times when smart money has determined that something is wrong with the stock or underlying fundamentals of the stock.

As you can see, SBC Communications (SBC) began "Stage 1" back in early July and entered "Stage 2" in early September. The last time SBC showed similar relative strength characteristics was back in October of last year and lasted well into November. A trader that begins to understand relative strength can then go to a bar chart or conventional point and figure chart and look for similarities between the two time periods (now and then) to set up their trading strategies.

Free relative strength charts like that above are available at www.stockcharts.com. Just go to the point and figure chart section, type in the stock symbol you want, then at the bottom of the chart go to the "enable button" for relative strength and enter the index you wish to measure against. The symbol for the Dow Industrials is $INDU, S&P 500 ($SPX.X) and NASDAQ Composite ($COMPQ).

In coming updates we'll be identifying bullish candidates and bearish candidates alike. Subscribers that have been following some of our past articles on Abercrombie and Fitch (NYSE:ANF) will understand how relative strength was used to identify a short/put candidate in the $40 range. Bullish traders may want to take a look at the relative strength chart of AT&T (NYSE:T). This stock is in early "Stage 1) and has quite a bit of distance to go until it reaches what could become "Stage 2." Relative strength is a great tool to be using if you're a LEAPS investor.

Jeff Bailey
Senior Market Technician
www.premierinvestor.net

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