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Starting to see divergence in Dow Industrials

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Every Friday, I review our Dow Industrials "hypothetical" portfolio that we established based on a $1,000 investment in each component on one of the worst days you could have probably imagined investing. That day would have been September 10th, the day just prior to the terrorist attacks here in the U.S.

Yesterday, shares of Merck (NYSE:MRK) seemed to single handedly turn a market rally into a market stall. Here's what I think is happening and how Merck and the internal action of the Dow Industrials is impacting the market in a negative way.

Dow Portfolio "hypothetical" $1,000 investment on Sept. 10

Just since yesterday, I've started to see the lower 15 stock in the Dow Industrials (ranked by performance since Sept. 10 close) really start to under perform. Just last Friday, this portfolio had 18 stocks trading with gains from their Sept. 10th close, but now those stocks in the #16-#18 slots are all showing losses of better than 5%. This is some significant internal damage.

Merck (NYSE:MRK) is the culprit right now. That stock was ranked #16 as of Friday's close and has dropped all the way down to a #28 ranking. That action by itself put a lot of downside in the Dow Industrials Average.

I think that action, by Merck itself, really hurt investor psychology near-term. Not because Merck had fallen, but what it did to the Dow Industrials Average. That seemed to give the Dow a psychological setback, and if not treated soon with a good dose of Prozac, or a generic substitute.

What we're starting to see take place is a case of narrowing leadership and loss of bullish breadth in the Dow Industrials. Currently, the bulk of the gains are found in the upper tier stocks, while the lower tier stocks seem to be eating cake, enjoying life and just along for what had been a nice Dow rally that began back in late September/early October.

What can happen near-term is the dynamic we've talked about as it relates to a snake or even an inchworm. Right now the tail is trying to head lower, while the head has been trying hard to lead and move higher. Eventually, the snake will stretch like a rubber band and one end has to give, otherwise things go "snap."

In a "recovering economic" cycle, it's important for the lower end stocks to carry some type of weight. While the leaders are trying to assert themselves as money flows into them, that will continue only so long. Eventually there are big profits that begin to reside in these stocks (see the PL % column) and imagine you're an institutional investor/trader that has about 1,000,000 shares of each of these stocks.

Also imagine you're the more "typical" investor that ends up selling their winners because their losers just keep falling to levels most consider "undervalued." If the losers keep falling, then in this type of environment, those that have gained "must be overvalued" so that's the one I should sell.

Of course, this is often the worst type of logic to use. Sure, we will see rotation from time to time as some stocks will lose favor and rotate to the bottom of the pile, while another stock gains favor and rotates to the top. But right now, we're starting to see too many stocks start to rotate to the bottom and the PL % to the downside of those stocks benchmarked from the Sept. 10 close is beginning to concern me as it relates to any further bullishness.

That "lack of bullishness" is what can eat away at a bulls psychology and mental state. With the Dow Industrials back below the 10,000 level and not having been able to close above the 200- day moving average, investors and traders should be getting more cautious right now with their bullish trades. Especially for those that are overextended on their charts!

Now that we've looked at the internals of the Dow Industrials and see what is going on, lets check the outward appearance and see if the Dow Industrials (the patient) is showing any outward symptoms that the internals are look to be depicting. WEAKNESS would be the word.

Dow Industrials Chart -

Yesterday we were talking about trends and if some of the upward trends we were seeing were "reasonable." Yes, the trend is your friend and it should be traded. Today's action in the Dow Industrials has an aggressive upward and short-term trend being violated to the downside.

From here we want to monitor the technicals of the patient and the outward appearance. We must also monitor the internals. What a bull wants to see is the bulk of the insides start to improve. It's much easier to "discount" a simple case of diarrhea in the case of MRK as a symptom of a bad meal that just didn't sit right, but we need to be monitor the internals to make sure we don't have some type of intestinal outbreak of a major bacteria in the intestines of the Dow. If that turns out to be the case, then this patient could be bedridden for sometime. And that could put a damper on investor psychology and spill over into how other stocks trade.

I'd love to do this with the NASDAQ-100, but 100 stocks are very hard to follow/write about in these kinds of updates. Hopefully traders get the feel for how looking at some internals as well as the externals can help you in your market analysis.

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

The Dow Industrials is only 30 stocks and not necessarily representative of the broader market. But hopefully the bullish percent chart along with the above discussion will help traders understand this valuable tool of quickly monitoring the internals of the market. Based off of simply measuring the number of buy/sell signals created on the point/figure charts, the trader/investor gets a very good feeling for internal risk and strength. Last night's reading was 63.33% of the Dow 30 stocks were on a point/figure buy signal. That means 19 of the 30 were still showing a buy signal. This is not an "overbought" level and we can measure this each day.

Subscribers will note that even though Merck (MRK) gave a glaring sell signal yesterday, that stocks was already on a sell signal which occured in early November at $64. Once a stock gives a sell signal it cannot give another sell signal that takes away from the bullish percent indicator. It's very black and white. Either a stock is on a buy signal or it is on a sell signal. No "in between" for supply/demand.

Also note... as it relates to the Dow Industrials bullish percent. Current market status is "bull confirmed." A reversal to 56% would have the Dow Industrials entering a "bull correction" phase. If I owned an "overextended" stock trading in some type of aggressive upward trend, what might happen to that stock in a simple "bull correction" environment? Chances are those hefty profits will erode somewhat, but the pullback would most likely offer another attractive bullish trade.

Jeff Bailey
Senior Market Technician
Option Investor

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