Option Investor
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The market is my inchworm

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To many, the stock market is just a bunch of stocks that move in a somewhat random and uncoordinated gyration. To me, the market is an "inchworm" where the moves up or down are coordinated through a unique, yet measurable rotation of money.

Just as our relative strength charts and bullish percent charts depict this rotation of cash on a more "internal" basis. The broader market averages are an "outward" reflection of what is taking place on the inside.

Here's my artist rendering of how I feel a bull market is created and moves higher. Just the opposite would be true for a bear market like we've been in. Let's look at a monthly chart of the Dow Industrials. We'll use a retracement bracket from the all- time highs to the recent lows. This will now be known as "the range of the inchworm."

Dow Industrials Chart / Inchworm example

Maybe its childish to look at the markets like an inchworm, but if you think stocks move in a random fashion or don't quite understand "how thing work" then this example might help. The Dow Industrials have recovered just about 50% of their declines (based on our retracement bracket above) from the January 14, 200 close of 11,722. I'd say the "inchworm" has expanded.

The only question I can't answer is how long is the inchworm I'm dealing with? Is it an inch long, or is it two inches long?

Now, that Dow Industrials "hypothetical" portfolio we've been monitoring becomes the internals of the inchworm. Those at the top are at the head of the inchworm and those at the bottom are the tail.

If we understand how an inchworm moves, we then understand that an inchworm moves very systematic. The head of the inchworm always moves forward, so perhaps it is best to think of the market as being a two-headed inchworm, with a head at both ends of the body. He can move in either direction.

Now, lets imagine that I have no clue (which I don't) of how long this inchworm is we're dealing with. Where do I place some bets? For the inchworm to move, there needs to be some type of consolidation, or coil action. The "safest" bet right now is to concentrate on the "middle of the worm" and look for stocks that are moving up in "ranking." These are the stocks in the middle of the body.

This is very important for the trader/investor right now to understand, especially if they're wondering if it's "too late" to invest in the market as we've seen a powerful rally higher.

Today, the top three stocks of the "inchworm" we've been monitoring called the Dow Industrials have Hewlett Packard (NYSE:HWP) #1, Wal-Mart (NYSE:WMT) #2 and IBM (NYSE:IBM) #3. Between the three, they are up between 18-23% each since September 11th.

At the tail, we've got Eastman Kodak (NYSE:EK), Boeing (NYSE:BA) and Walt Disney (NYSE:DIS). Between these three, there losses range from 37%-17% since September 10th close.

For those just looking to get involved again (committing new capital at this point), I think it best to focus on the mid- section of the inchworm at this point. Then, if we go into a point of consolidation or coiling, I'm not at the ends of the inchworm where a I would have a great probability of being in some part of the inchworm that could make a move against me.

Now, I will preface the above paragraph by saying it is best to be in stocks near the front of the pack in a new bull market, if indeed the inchworm is headed higher. But those just looking to get involved again are a little late, but still able to make some good money going forward, with exposing themselves to a great deal of risk.

I'm still trying to stay away from those stocks in the "tail" section of the inchworm. The only time I want to even consider anything in the tail section, is AFTER I've locked in some nice gains and have quite a bit of breathing room in my account and can then look for a "flyer" that might be looking like its getting ready to rotate to the head of the pack.

The most notable "rotation" that we've seen in the Dow portfolio has been that "telecom" and SBC Communications (NYSE:SBC) along with AT&T (NYSE:T) rotated to the bottom of the worm, while IBM (NYSE:IBM) and Hewlett Packard (NYSE:HWP) have rotated to the head. Also having rotated near the front has been Intel (NASDAQ:INTC) "semiconductor" and Microsoft (NASDAQ:MSFT) "software". That's funny. Semiconductors and software are both components of computers!

Now.... Citigroup (NYSE:C) "financial" has been holding near the head and currently resides in the #4 slot. JP Morgan (NYSE:JPM) "financial" is ranked #14 and this would be the "middle section" of the inchworm. What I want to do now is look at relative strength of JPM and also study relative strength of C to get a feel for how things HAVE played out, and what MIGHT play out should something be taking place in a sector move near-term.

As I've mentioned recently.... two stocks I've liked in recent sessions are General Electric (NYSE:GE) "electronics" ranked #13 and yesterday in the "market monitor" on OptionInvestor.com I mentioned shares of International Paper (NYSE:IP) #15 "forest/paper" as a bullish candidate.

Going forward

Now we have what we'll call the "inchworm scenario" to monitor going forward. It takes little effort to simply track 30-stocks on a daily or even weekly basis and will help keep us in tune with things.

If we understand how an inchworm moves, then we can better understand what the Dow Industrials internals (30 stocks) are telling us.

The more bullish longer-term moves come from the inchworm's head holding still, and the tail section inching forward. So far we have not seen this type of action. The tail has pretty much been anchored in place as the "head" has stretched higher. Those stock in the middle portion have moved higher as a result of the "stretching" of the inchworm.

Going forward , bulls want to see some of those stocks in the tail section start to move higher, otherwise I think we're going to get a bit of a rubber-band reaction from the head as the market consolidates or coils before the next move.

If the head "snaps back" and the tail end stocks head lower, then watch out below! However, if we get some pullback in the head, some move forward in the tail, then watch out above! That's when the inchworm, when he expands, would most likely have the Dow Industrials surging higher!

Stockcharts.com is having problems with their Internet Service Provider and I can't display or view their relative strength charts. When they get back up and running, we'll be better able to look at some relative strength charts, which are very important in our stock selection process.

Jeff Bailey
Senior Market Technician
Option Investor

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