This column was originally published on RealMoney on Jan. 4 at 11:57 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here .

Let's look at the Dow Industrials and see which components might turn into the venerable index's biggest losers in 2007. This follows my belief that opportunities will abound on the short side during the first quarter as last year's rally unwinds and market players look for ways to take advantage of overheated bulls.

This isn't a bearish call for the broad market this January. Frankly, I'm not sure what's happening right here. Blue-chips are holding their own while tech stocks are getting beaten up. But inflows into retirement accounts could heal technical damage quickly and support higher prices. I'd rather let the scenario play out than make grand predictions.

Admittedly, though, bulls are stuck in a tough position after the strong 2006 run. The major indices never consolidated their substantial gains between July and December. This one-way market has set up an unstable pattern that could trigger an intermediate correction, or several months of sideways chopping marked by uncomfortable downdrafts.

The Dow Industrials are a good place to look for emerging short sales because of the way capital flows among its 30 components. There's just a finite amount of money behind all the buying and selling of the stocks on the index. This sets up large-scale rotation throughout the year, with the hottest stocks getting hotter and the coldest stocks getting colder.

This closed system insulates short-sellers, to some extent at least, from squeezes that impact the broad tape.

This extra layer of protection will be important going forward, because all the major indices are still trading near multiyear highs.

So these shorts will have a good chance to survive even if the market resumes its strong uptrend.

When a Dow stock flips to the cold side, it can sell off for months before willing money takes on new long positions.

General Motors ( GM) offers a great example of what can happen when an index component falls out of favor.

The stock hit a 15-month high in October and rolled over.

It got sold hard throughout the fourth quarter.


The bounce that started in mid-December shows weak participation and should offer a good short-sale entry. But timing cycles suggest sellers will want to stand aside a while longer and let the recovery play out. Watch for a break of support at $29 marked by a broad selloff day on 30 million shares or more. That event should offer a reliable signal for new sales.

It looks like another bad year for Intel ( INTC). The stock failed to participate in the fourth quarter rally and is getting little support from news flow in the semiconductor space. Notice how the stock has been chopping around the 200-day moving average for the last three months. A breakdown here could mean serious profits for short-sellers.

Price broke this support level over the holiday week, but the thinly traded action could be misleading. So let's sit back and see how the stock trades in the early January market. A failure to bounce strongly in the next week or two will invite aggressive, new short positions for a decline back to the multiyear lows at $16.75.

Caterpillar ( CAT) has been unable to recover from a nasty gap-down event following its third-quarter earnings release in October. The good news is, it's still trading above the low of the selloff day. The bad news is, it's rallied just 2 1/2 points in the last 10 weeks. This sets up the probability of another sharp downdraft in the weeks ahead.

Fourth-quarter price action has drawn out a well-delineated bear flag pattern, with current support near "round number" $60. Watch this line in the sand closely. A breakdown from this level should increase downside momentum and violate the October low rapidly. In turn, the progressive decline could run all the way down to the late 2005 low at $48.

United Technologies ( UTX) was a relatively strong Dow performer until its uptrend failed in October, when it tested the five-month high. The ensuing pullback has been gathering force and might be the first phase of an extended downtrend. The key lies right at the 200-day moving average, where the stock has been trading for the last two weeks.

The stock gapped into this support level on high volume. It bounced immediately, but the recovery was cut short by a wide-range selloff as soon as it filled the gap near $64. Now all eyes are focused on the lows of the downturn near $61. A breakdown there will also break the 200-day moving average and trigger all kinds of sell signals.

The long-term view on 3M ( MMM) supports a bearish outlook in the first quarter. Note the sharp oscillations in the weekly pattern over the last three years. It's clear this stock tends to swing very hard when it shifts direction. The October high near $82 could mark yet another cyclical turn.

The stock sold off from $88 to $67 in the first half of 2006. The summer rally stalled at the 62% retracement of that rally, which marks a classic failure level. The congestion pattern during the fourth quarter shows much greater distribution than expected. This selling pressure could flag an eventual breakdown and decline back to last year's low.
At the time of publication, Farley had no positions in any of the stocks mentioned, 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; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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