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How Can a Market Rise in the Face of Bad Economic News?

While the latest rally might be over, it is interesting to ponder how the market could have had such a powerful rally while the news continued to show the economy sinking.

The New York Federal Reserve’s Manufacturing Index fell greater than expected in June, surprising economists; and there is no point reiterating the negative news about the economy that we constantly hear on TV or in our local papers. The only thing is…the market was rising. Why?

Well for one thing, the reports we hear are old. The Fed’s report for New York was for the month of June. It is now August. Things are changing for better or worse but they are not the same today as they were just two months ago. In addition, the market attempts to look forward. The market wants to know the earnings outlook for June 2009, not last June.

And even as the news of the manufacturing index was announced (remember it was for June) the news of an increase in industrial production was released showing a .2% unexpected rise. And moments later the empire state index was announced showing a rise in August.

In this vein, the warta ekonomi seems to be improving in some key areas.

Last week I mentioned the strategy the Fed was pulling off which allowed it to stand on its Bully Pulpit, railing against the rise in inflation and promising to stem it, all the while eyeing future prices knowing that inflation will be moderating over the foreseeable future.

Here are some of the numbers.

Oil broke 114 last week hitting 112.75.
Gold has been severely damaged, falling to 782 an ounce, down from its peak of 1033 an ounce in March…
Silver has dropped 12%
Corn and copper have declined along with other important commodities, such as rubber and wheat.

These are just some of the reasons why many say that there has been an increase in the value of the dollar. The dollar now buys 5% more Euros than one month ago.

Lower inflation will help all of us. We are already seeing it at the pump. And if it continues, we will see it in other parts of our wallet. This will free-up some money for us to spend on other things and save a little more.

The market was taking note and rallying in advance of this potential future.

Now this is not to say we are out of the woods. We certainly are not. If you look at the markets and look at them technically, this recent strength is tentative at best. The sellers still have the upper hand.

For example, the NASDAQ has currently been outperforming the Dow. The NASDAQ is more heavily weighted toward technology stocks, and technology stocks are often the first ones out of the gate in a new bull market. I am seeing something else though. While buying has been more intense in the NASDAQ than other exchanges, buying has been very selective. Let me explain this because it is an important concept.

The price movements of most indices, with few exceptions, are more influenced by the big companies in the index rather than the small. The stocks that are included in these indexes are weighted by size or capitalization. General Electric has much more influence over the S&P 500 than Radio Shack. If a company’s size is more heavily weighted, a small movement in the price of the large stock will have more influence on the value of the index that a bigger move in a smaller stock.

So here’s a clue. An index may rise because a few large companies in the index have risen, but in total the overall number of stocks in the index may still be falling. This is exactly what has happened. Taking data from a recent up day in the NASDAQ, for every 100 stocks that increased 160 stocks declined will result in a negative ratio of 1.6 to one. This happened on an up day! Not a healthy sign.