How the Market Really Works

Long-term investors like to think in terms of fundamentals, and that usually works. However, the holy grail of investing is the ability to select the right asset classes at the right time. Unfortunately, fundamentals don't always determine which asset class is hot. Valuations are often guided by wave-like changes in sentiment, fashion, and fear. So where is the next wave hitting?

Go-go tech
Consider the technology bubble of the late 1990s. With the benefit of hindsight, it's easy to conclude that valuations simply got too high in the late '90s. Indeed, a quick look at the performance of the Nasdaq-100 index demonstrates the kind of bubble created back then. Investors in the PowerShares QQQ (NASDAQ: QQQ  ) (an ETF that tracks the Nasdaq-100) will be hoping to see more of the same in future if equities are the next hot asset class.

^NDX Chart

^NDX data by YCharts.

However, what happened in the late '90s was a consequence of sentiment changes that actually affected the fundamentals and, more importantly, how investors perceived them. The bubble came at the end of a 20-year bull run in equities -- particularly technology stocks. As more and more money went into tech, more value got placed on buying technology solutions. The tech companies then made more money, and their fundamentals started to look better. This is the sort of argument that fits well with George Soros' view of reflexivity in financial markets.

For example, a market buzz builds up around a certain tech product -- say, customer relationship management software. Investors bid up the stocks of companies that offer these products, articles about CRM appear in business magazines everywhere, and every corporate manager is convinced he has to buy a shiny new CRM solution. The CRM vendors start making more money, and the upward moves in their stock prices now look justified based on fundamentals. Unfortunately, these positive-feedback loops don't last forever.

Let's try housing
The ensuing stock-market crash was painful for investors and made people fearful of equities. The Federal Reserve model whereby equity valuations are compared to Treasury yields broke down after the tech crash. The resulting recession was met with interest rates cuts, which then spurred investment in yet another asset class that turned into a bubble -- this time, housing.

The following chart demonstrates the relationship between U.S. housing starts and a housing-related ETF -- namely, the SPDR S&P Homebuilders ETF (NYSEMKT: XHB  ) .

US Housing Starts Chart

U.S. Housing Starts data by YCharts.

Gold, oil, commodities, China, you name it
As the chart demonstrates, the housing boom was actually over by 2007. Investors then did what investors do and shifted to a new asset class. This time it was anything but equities or housing. China was the new dot-com, and oil and commodities were the only game in town. Even while the financial crisis was in full swing, oil and commodities still surged in the first half of 2008.

You can see this in 2008, when the CRB Index -- a weighted catch-all commodity index that contains oil, gold, and soft and hard commodities -- spiked and then crashed as the reality kicked in.

^CRB Chart

^CRB data by YCharts.

Of course, the media isn't full of stories of hedge funds buying up commodity futures contracts anymore, because the CRB index has fallen over the last two years. Moreover, the gold mania appears to be over for the moment, especially after the precious metal had a difficult year in 2013. The chart below shows the price of gold in U.S. dollars and the performance of popular gold ETF SPDR Gold Trust (NYSEMKT: GLD  ) .

Gold Price in US Dollars Chart

Gold Price in U.S. Dollars data by YCharts.

Back to equities?
Given the gains in the major market indexes in 2013, it's easy to conclude that fashion and sentiment has shifted back toward blue-chip, dividend-paying equities. The good news is that these sorts of shifts in sentiment can last for several years.

For long-term investors, such considerations won't matter too much, because their focus will be on whether they are happy with the underlying fundamentals and valuations of the businesses they invest in. However, for investors looking for the the asset class favored by sentiment at the moment, then the equity market is a good place to look.

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