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The

Dow Jones Industrial Average

has recovered most of the losses it incurred in the big selloff and is now not far from its 2007 high.

This places its performance on par with the

Nasdaq Composite

and just behind the

S&P 500

, which has led the recovery effort in the past six weeks.

Notably, the Dow's multiyear breakout over 11,700 last October is still intact.

This keeps the venerable index on track to eventually take out this year's highs and head toward 15,000 in the months ahead.

But price must still overcome the considerable barrier imposed by this year's high.

That might take another few months, at least.

Curiously, the first-quarter selloff now looks less ominous than last year's second-quarter correction, which took more than three months to hit bottom.

What also sets 2007 apart from last year was the near-hysterical cacophony of bearish predictions.

It's now obvious that price action never matched these endless doomsday calls.

But a cautious stance is required at this juncture, despite the good tidings we feel as the Dow and other indices set their sights on the old highs.

Sadly, these lost levels mark solid resistance.

That raises the likelihood of another sharp downturn as price approaches those boundaries.

I'm not looking for a vertical slide here. Most likely, we'll see the development of a broad range that defines the trading environment in the second quarter. With better luck, the next pullback will be shallow and hold the major moving averages at high pivot levels. In turn, that platform could set up an eventual thrust to new multiyear highs.

Expect the double-top crowd to come out of the woodwork following the next downturn. The bears are still looking for signs that this rally will fail. A well-publicized selloff, just as the major averages near their highs, will be their excuse to reload positions that have caused them grief during the endless squeeze in March and early April.

Despite their efforts, the Dow should hold firmly above intermediate support at the 50-day moving average, now at 12,425. I'll be watching this price level for an upside turn that precedes a breakout. But that might need to wait until May or June, at the earliest.

The Dow's fate rests firmly on the backs of its top performers and comeback kids for 2007. Logically, these should be the issues that lead the average higher after short-sellers load up in expectation of another ugly downdraft that, hopefully at least, will never come to fruition. Let's identify these leadership stocks.

Merck

Merck

(MRK) - Get Report

jumped to the top of the Dow leader list last week after

raising its guidance. The subsequent breakout completes the stock's recovery from the Vioxx-driven breakdown in late 2004 and places the stock firmly at a three-year high. Heavy volume during the move predicts the start of something big.

The longer-term pattern shows that price can run at least 8 more points before hitting a substantial barrier. The emerging uptrend should let up at that time, with the stock dropping into a consolidation phase. In the meantime, look for this market leader to help the Dow's run at new highs.

AT&T

AT&T

(T) - Get Report

has been on a roll since completing its BellSouth merger, with the stock pushing up to a five-year high in a steady uptrend. However, it failed to participate in last week's broad rally. This suggests that price will pull back in the short term, as it works off volatility from its strong March rally.

This pressure could yield a decline that tests parallel channel support near $36.50. A pullback in this component supports my observation that the Dow may be headed for lower prices as well. But once again, the correction should be contained and represents an eventual buying opportunity for a run to new highs later in the year.

Altria

Altria's

(MO) - Get Report

long-awaited spinoff of

Kraft

(KFT)

has been well received by Wall Street, with the stock rising more than 10% in the past three weeks.

It's now trading at an all-time high in a wickedly strong pattern that predicts the rally will continue into the middle of 2007 at least.

The stock is now working on a bull flag pattern near the recent high at $71. This suggests that price will eventually start a measured-move rally that equals the distance of the March run beginning at $62.

This yields a short-term reward target in the upper $70s.

Altria is definitely the Dow stock to watch in the next few weeks.

McDonald's

It may come as a surprise that

McDonald's

(MCD) - Get Report

is the strongest Dow performer right now by a wide margin. Its leadership position confirms that our craving for fast food hasn't diminished, despite nutritional warnings and award-winning documentaries blasting Mickey D's effect on waistlines worldwide.

The stock is now approaching its all-time high, struck back in the late 1990s. This should trigger at least one downside reversal. So, this one appears headed for a pullback in the short term, like other Dow stocks reviewed today. But strong buying pressure during the run-up should provide support in the lower $40s and eventually set up a rally to new highs.

At the time of publication, Farley had no positions in the stocks mentioned in this column, although holdings can change at any time.

Alan Farley is a professional trader and author of

The Master Swing Trader

. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;

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