DOW STARTING TO SHOW LEADERSHIP -- NEW DOW LEADERS ARE CITIGROUP, DUPONT, AND 3M -- DOW IS NOW IN FIFTH WAVE ADVANCE

DOW STARTING TO OUTPERFORM NASDAQ ... I mentioned yesterday that the Dow Industrials were starting to catch up with the rest of the market after reaching a three-year high on Tuesday. Actually there's more to it than that. If the Dow is starting to do better than the rest of the market, that has some bearing on sector rotation strategies. It may also be carrying an early warning sign for the stock market. Chart 1 is a ratio of the Nasdaq Composite Index divided by the Dow. Since August, the falling ratio means that the Nasdaq has been rising faster than the Dow. Nasdaq leadership is usually a good sign for the market. Since the start of December, however, the Dow/Nasdaq ratio has been rising. Not enough to signal a major shift yet, but enough to suggest that some rotation into Dow stocks is starting. But what does that mean? Chart 2 shows the same ratio for the last two years. The first thing to notice is that the Dow/Nasdaq ratio is at the same level as at the start of 2004. That puts the ratio in a potential support area. The upturn in the ratio at the start of 2004 also coincided with an intermediate market top. Dow outperformance is usually associated with a more defensive market. Notice also that the peak in the ratio in August marked the start of the latest market upleg. In other words, a falling Dow/Nasdaq ratio is good for the market, while a rising ratio is bad. Chart 3 shows that's been the case for the last nine years.

Chart 1

Chart 2

Chart 3

RISING DOW/NASDAQ RATIO IS BAD FOR MARKET ... Chart 3 shows the Dow/Nasdaq ratio since 1996. The falling ratio from 1997 to early 2000 was associated with rising market that was mainly concentrated in the Nasdaq (see first green arrow). The bottom in the ratio during 2000 marked the start of a two-year bear market led lower by the Nasdaq (red arrow). From early 2000 to the end of 2002, Dow stocks did much better than the Nasdaq. The ratio peak at the end of 2002 (second green arrow) marked the start of the cyclical bull market that's still intact. Which brings us to the present. The Dow/Nasdaq ratio is testing support going back more than three years (red trendline). And it's starting to bounce. So far, the bounce is small. If it continues, however, that would be an early signal that investors are starting to switch out of Nasdaq stocks into Dow stocks. In the past, that's usually been associated with a more defensive market.

DOW DECEMBER LEADERS ... Over the past couple of days, Pfizer has been the top percentage gainer in the Dow as it recovers from last Friday's drubbing. [The rebound in Pfizer is also supporting the drug and healthcare sectors this week]. Over the last week, the top percentage gainers in the Dow have been AIG, Citigroup, Intel, 3M, and United Technologies. UTX is trading at a record high. Intel bounced this week after a brokerage upgrade while AIG has been recovering from an October price plunge. The charts of 3M and Citigroup, however, show were some of the new Dow leadership is coming from. Chart 4 shows 3M trading over its 200-day moving average today and nearing an upside breakout. Its relative strength line (measured against the Dow) is starting to outperform the Dow after underperforming since July. [The ratio is bouncing off its early 2004 low]. That makes 3M a potential Dow leader. Citigroup is another emerging Dow leader.

Chart 4

Chart 5

CITIGROUP BREAKS OUT ... Chart 5 shows Citigroup breaking out to a new eight-month high and on rising volume. It's also trading well above its (red) 200-day moving average. Its relative strength line is also promising. The Citigroup/Dow ratio peaked in April and has been dropping since then. During the last month, however, the ratio line has broken its 2004 down trendline and is bouncing. That makes Citigroup a new Dow leader as well.

DUPONT BREAKS OUT OF MAJOR BASE... For the entire month of December, some other top percentage gainers have been Caterpillar, Merck, and Dupont. Merck has been recovering from its early November price plunge. Caterpillar has been rallying for sometime and is trading at a record high. Chart 6 shows Dupont exploding through 46 this month to reach a new 52-week high. The DD/Dow ratio line turned up in mid-November, but hit a new high just a couple of weeks ago (see blue circle). That makes Dupont another recent Dow leader. In case you're thinking that the stock is "too high" to consider purchasing, take a look at the monthly bars in Chart 7. They show Dupont having just broken out of a major bottoming pattern extending back to the first half of 2000. That's very impressive. That's also why it's smart to look at long-term charts. What looks "high" on a daily chart may look "low" on a monthly chart.

Chart 6

Chart 7

FIFTH WAVE DOW TARGET ... The monthly Dow bars help put things into better perspective. I mentioned yesterday that, with the Dow having exceeded its early 2004 peak, the next resistance barrier was the early 2001 peak at 11350 (see circle). That's about 4.8% from current levels. I think there's a strong chance the Dow will get there early in the new year. But therein lies a potential problem. As I've suggested in the past, the "cyclical" bull market that started at the end of 2002 appears to have entered its fifth (and final) upwave. At least that's how it usually works. Bull markets normally take place in five waves. Even allowing for the subjective nature of Elliott Waves, the ones marked off on the chart look pretty convincing. And it looks like the Dow is now in its fifth wave. That's good news over the short-run, but suggests problems after the fifth wave has been completed. I suspect that could happen early in the new year -- possibly after the strong November-January seasonal bulge has ended. But, as I suggested yesterday, let's worry about that later. Right now the market is rising and it looks like Santa Claus has made his annual visit to Wall Street to spread good cheer. On that bright note, I'd like to take this opportunity to wish everyone a very Merry Christmas.

Chart 8