Financial markets turn out to be extremely valuable in terms of getting at the underlying value of a business, and some may wonder just how all of this works.
At a high level, millions of transactions from millions of individual market participants who buy and sell these securities every second forms a sort of “collective knowledge.” The efficient market hypothesis is a derivative of this idea. Some may think that holding all information static, one ought to be confident in financial markets due to the theory that they efficiently price asset classes always.
Of course, this is not always true, largely due to the variance in forecasting related to future earnings of companies, the various key factors involved in forecasting such as growth rates or interest rates, and the overall sentiment of the market at a given point in time.
Some sectors thus find themselves in “unloved” territory in which they present attractive long-term buying opportunities at the same time as other sectors may clearly show overvaluation due to “animal spirits” or “irrational exuberance” tied to future expectations.
Measuring asset classes on a relative basis to historical performance is a great way to measure market sentiment on an asset class at a particular point in time.
For example, looking at how certain asset classes typically read to interest rates and mapping out the variance one sees in stock prices to this metric can be helpful. The past is not a perfect predictor of the future. However, regression toward a longer-term mean is a helpful concept every investor should internalize, particularly in volatile times such as these.
Invest wisely, my friends.
