Option Investor
Index Wrap

Rotation!

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I'll never think I know "everything" that is taking place in the markets, but as today's action unfolded as we thought it might as outlined in last night's Index Trader Wrap, where the path of least resistance did find the NASDAQ-100 Tracking Stock (AMEX:QQQ) $37.68 +0.91% leading a recovery from morning weakness and trading new highs, it is somewhat apparent that the "once leading" Dow Industrials (INDU) 10,529 -0.09% lags a bit as it battles the upper-end of our regression channel.

While this market trades BULLISH, its also trading just like an inchworm moves!

That right! The good old "inchworm analogy!"

For those that haven't been with OptionInvestor.com all that long, a good article I think traders and investors might want to read is found in the Bailey's Basics section of the site, titled "The Market is my Inchworm." http://members.OptionInvestor.com/archive/intraday/2002/052302_3.asp

Clear your head of UP versus DOWN right now, and close your eyes and envision how an inchworm moves. How does it move? An inchworm is about an inch long. It can only move in one direction one inch at a time. To get from point A to point B, it moves by fully extending itself, then as if some type of suction cup is attached to its chin, it coils its body, by allowing its tail to move toward its head. If the inchworm is going to move from point B to point C, it then has to anchor its tail, release its head, expand, until fully extended again.

Where am I going with this?

You observe, like I did today, that the NASDAQ-100 (NDX.X) +0.86% did extend itself further today, while the SPX +0.23% and OEX +0.27% edged up fractionally, while the INDU -0.09% traded fractionally lower.

All of these major indices make up what we call a "market." There's duplication of stocks in all of them, but as traders and even as investors, I'm seeing significant signs of rotation, all which can be very healthy for a longer-term bull market, where the bull market can last longer, and be more POWERFUL than we as humans can ever comprehend!

I'm not a biologist, I took a biology course in college, and I'm not sure what the internals of an inchworm is comprised of, but I envision it as being some sort of plasma material. I would think this plasma material moves no different that blood might in the human body. A blood cell at the top of my head right now, might be pumped down to my feet in the next couple of hours.

Rotation! Maybe I should say "circulation!"

I want to FOCUS ON THE NEGATIVE right now. The Dow Industrials (INDU). Why all of a sudden, does the INDU stall out for the past 3-days? I ask this of myself, and not just of you.

How does the Dow Industrials (INDU) move? You and I know it is a PRICE weighted index, which is comprised of 30 stocks. This means the HIGHER PRICED components provide more influence in how the INDU moves. If each Dow component is a plasma/blood cell, then some are bigger than other right?

Tonight I'm gong to go back to this past weekend's "Ask the Analyst" column, as I think I can PROVE that rotation can be healthy, and that it does take place. The Dow Industrials are easier to understand, as there are only 30 stocks that comprise it.

Check this out.

I established a portfolio of 2003's worst performing Dow components, simply to begin monitoring what a trader had asked about in regards to a strategy discussed, whereby a bullish investor bought the 5 worst performing Dow stocks of last year, as a perceived value play, that these 5 stocks might outperform the Dow Industrials itself in 2004, as they gravitated back toward the mean. This is somewhat similar to "rotation" or "circulation" of capital isn't it?

How can I make an observation of circulation or rotation within the Dow? Since I know it is a PRICE weighted index, I thought I'd add another set of data, and see how the HIGHEST PRICED components, which are more heavily weighted, are performing.

I also make the observation of how the Dow Industrials Index (INUD) itself, or as a whole (the inchworm) has performed since its December 31, 2003 close. This is what YOU and I may be contemplating on trading right now (buy or sell) / (demand or supply).

Dow Industrials Component Breakdown - From 12/31/03 close

The 5 Dow components at the top of the above table were last year's worst performing Dow stocks (% loss), where I placed a hypothetical $1,000 (no rounded shares) in each stock. This enables us to measure this group of stocks, where my observation is that these 5 stocks are currently up 2.99% since their December 31, 2003 close. I've labeled these stocks with the term "tail" as these were the weakest stocks in 2003.

The next set of 5 stocks, were the 5 HIGHEST PRICED components at the end of 2003. In essence, these 5 stocks are weighted more heavily when it comes to how the Dow Industrials (INDU) moves, or fluctuates in price. These 5 stocks currently show a -0.44% decline for 2004, where my observation is that while the year is young, there has been some rotation away from these HIGHER priced stocks in the first four sessions of 2004. Note, these stocks are not labeled with the term "head" as these were not the leading percentage gainers of 2004, but the observation of these HIGHER priced stocks may be an important observation in understanding why the Dow is moving as it is.

An finally, the benchmark, at the very bottom of the table is the Dow Industrials Index (INDU) itself, where for benchmarking purposes only, 1 "share" is entered as if purchased on the closing tick for December 31, 2003.

Conclusion: Rotation is taking place, which appears to be bullish, based on the observation that the Dow Industrials (INDU) is up 0.72% year-to-day.

Interpretation: The market, or market participants may indeed be putting bullish capital to work, where VALUE is perceived in the Dow Industrials, in the form of buying last year's worst performing stocks. It is uncertain if the buying is being created by bearish short covering, or overly bullish enthusiasm.

Note: There is not a 4-lettered stock in the above table, which would indicate a NASDAQ listing. Those stocks noted above are listed on the New York Stock Exchange.

Question: For those that have been subscribers the past two months, up until December 29, 2003, when the NASDAQ Composite (COMPX) 2,077.68 +0.98%, what broad market index continue to trade new 52-week highs, after the NASDAQ Composite first traded the 2,000 level on December 3, 2003? You would be correct if answering with .... the NYSE Composite (COMPX) 6,525.30 -0.24%.

Do you see where we're going? The very broad NYSE was "the head" for the bulk of December, and now it looks as if BULLISH rotation takes place to the NASDAQ Composite (COMPX) 2,077.68 +0.98%.

It is uncertain, or undeterminable if the rotation is from new bullish buying, or bearish short covering.

Now... I profiled a BEARISH trade in the QQQ with a February $36 put, prior to the QQQ breaking above $36.00 and to new 52-week highs. I know from short interest reading on December 15, 2003 that short interest in the QQQ was at annual highs, which has me somewhat suspicious that there are bears doing some buying. I was WRONG to profile a QQQ February $36 put (as of today's close), but I am currently satisfied with recent bullish comments and profiling of QQQ swing trades, as I (Jeff Bailey) made an attempt to get back on the right side of the MARKET's trade.

How can an overall bullish market continue to build? As it relates to how an inchworm moves (up the tree, or down the tree) it appears that December's "tail" or the NASDAQ is moving toward December's "head" and should the head be able to anchor itself, another expansionary move could occur, in the direction of trend.

Market Snapshot / Internals - 01/07/04 Close

Volume levels remained brisk as the first full week of post- holiday trade reaches a mid-point, where intra-day A/D breadth comparisons between the NYSE and NASDAQ continue to suggest bullish rotation toward NASDAQ stocks.

NYSE and NASDAQ NH/NL readings - 12/01/03-01/07/04

Observations noted in our Dow Industrials component analysis may be present in the daily NH/NL breadth readings at both the NYSE: and NASDAQ. In the 5th column from the left, I've placed a pink box around some higher number of new lows in the NASDAQ, where we see this number diminishing. New highs at the NASDAQ have been building, and suggests bullish leadership returning. This bullish leadership would be measured from the NSDQ NH/NL 10-day average ratio at the far right column, when the 10-day average showed a 3-box reversal back up from a 90% reading to 96%. The NYSE NH/NL 10-day Avg. ratio (8th column from left) has been in a column of X as depicted by the color green. 5-day average ratios are shown to give a similar observation of a 5-day to 10-day moving average crossover. The 10-day average ratio is very similar to how a point and figure (supply/demand) chartist charts the bullish % indicators. The chart's full range is from 0% to 100%. Higher ratio readings give the observation of bullish leadership.

I've marked the daily NH columns with "head" and NL columns with "tail" as if to visualize an inchworm, which based on observation, usually moves with head pointed toward direction of travel. Current observation is that the inchworm is moving higher, or in investment terms ... bullish.

Traders are correct in their thought that markets will rise, and markets will fall. Leadership can turn from bullish to bearish. The answer to the question of how long the current leadership can persist is one that has never been answered.

Pivot Analysis Matrix -

I want to quickly follow up on some of last night's comments regarding the pivot matrix. The S&P Banks Index (BIX.X) 339.02 -0.3% session low of 337.61 did find intra-day support at its MONTHLY Pivot (337.88) and WEEKLY S1 (337.11) correlations, where coincidentally, the SPX/OEX found their session lows. I did not highlight in pink the SPX/SPY lows, but both were very close to the 1,118 and 112 levels observed last night.

I've highlighted today's low in the QQQ of $37.07. Late last night, I continued to do some investigating in the QQQ, trying to disprove my bullish thoughts. It was purely by chance that I saw the NASDAQ 100 Volatility Index (VXN.X) 21.91 -3.73% had dropped sharply in yesterday's trade, and remembered reading a comment that bulls were buying calls in exuberant fashion. However, my checks last night showed that the January $37 puts were the most actively traded option in Tuesday's trade, which had me writing in last night's Market Monitor, that this might have been a bullish "tell" for today's trade, not unlike analysis in our 12/17/03 Index Trader Wrap "Watch out for this tomorrow" where we had picked up on similar option activity just prior to an option expiration. http://members.OptionInvestor.com/Itrader/marketwrap/iw_121703_1.ASP

Our analysis at that time was that for the VXN.X to fall, with put option volume being heavy, it may not have been overly bullish traders in calls, but perhaps covered put sellers that were short the underlying QQQ, about to call its quits as the trade moved against them. Again... by selling puts, a trader is OBLIGATING themselves to buy the underlying back at $37.00. It has been my market training that it is institutions that tend to SELL options, while the "retail trader" is often found buying puts and calls as risk in the option is certain to capital exposed. I make the observation that today's lows in the QQQ were $37.07, where when tied to the more active selling in Jan $37.00 may hint of a $37.00 floor in the QQQ.

By NO MEANS is a bullish trader now to assume the work "floor" means buy with reckless abandon and become complacent. However, yesterday's option activity, combined with decline in the VXN.X, and today's price action is very similar to what was noted the evening of 12/17/03, but more importantly.... 12/18/03!

NASDAQ-100 Tracking Stock (QQQ) Chart - Daily Intervals

One path of near-term resistance in the MONTHLY R1 was taken out to the upside with some conviction in today's trade. In the Pivot Matrix I did "dash green" the MONTHLY R1 and DAILY S1 as tentative support and these two levels can be tied in with the MONTHLY 19.1% retracement of $37.29 and MONTHLY R1 of $37.36. On a 5-minute bar chart, I noticed that when the QQQ pulled back from between 02:20 PM EST and 02:25 PM EST, the QQQ kissed $37.36 then traded higher into the close. This action at $37.36 may make sense as it relates to how an institutional computer "thinks" and manages inventory. At 52-week highs, it is my thought that bullish inventory (supply) may be low, and when that level is taken out, then inventory must be replenished (demand). Eventually, at some point in the future, supply will outstrip demand, but it wasn't today.

S&P 500 Index Chart - Daily Intervals

I'm running way short on time and past deadline, but a bull would not want to see the SPX much below the 1,105 level in my opinion. I showed a futures chart if the e-mini's, and they too are approaching a "zone of resistance" at the SPX 1,130 level, where trader would be alert to some selling. No sign of weakness that I can find in this chart, but some rotation taking place I'm sure. To get a MONTHLY R2, I'm thinking the S&P Banks Index (BIX.X) needs to get back in gear. Again... everything has made a VERY nice run, but if looking for further strength near-term above MONTHLY R1, then the BIX.X is a sector I'd be monitoring.

Dow Industrials (INDU) Chart - Daily Intervals

"Out of nowhere" the INDU found support below the psychological 10,500. Still bumping against a zone of resistance at the upper- end of our bullish regression channel. This doesn't mean the INDU can't break higher, but may hint that some bullish profits are being taken, or rotation to lower priced components that aren't having as much bullish impact as HIGHER priced components in the price-weighted INDU.

Jeff Bailey

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