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The Biggest Market Myth There Is?

CNBC.com
Friday, 25 May 2012 | 7:07 PM ET

Any new investor who hopes to successfully buy and sell stocks should know that the market is not rational, Jim Cramer said on CNBC's "Mad Money." And desperate attempts to make sense out of the nonsensical can cost you.

Jim Cramer
Jim Cramer

Sometimes stocks or the whole market will go up or down for reasons that have nothing to do with the underlying prospects of actual companies. Sure, you’ll search for a legitimate answer and the media will offer a few as well. But there will come a point where you’ll have to admit, Cramer said, that the moves are “just nuts.”

Here’s one way to put things in perspective, though: If the market’s wild fluctuations can’t be explained by business fundamentals, then they are most likely the effect of money-management fundamentals.

A lot of times money managers, namely hedge funds, will be caught on the wrong side of their trades. They start selling to raise cash because their clients want their money back. Then their selling scares other investors into dumping their own positions, and stocks are brought down across the board. Next thing you know some pundit is on TV trying to explain why gold, historically a protection against volatility, is down on a day when the markets plummeted, too.

(RELATED: Cramer Explains How to Play Gold)

Mechanics of the Markets
Does it seem like the market is moving in lockstep? Mad Money host Jim Cramer is decoding the Street.

It wasn’t always like this. Back when Cramer first started trading in the 1980s, stocks were valued according to the underlying company. The share price depended on things like earnings, cash on the balance sheet, revenues and profit margins. But during that decade, stocks began to be lumped into giant baskets that mimicked, say, the S&P 500. As a result, stocks became an asset class that at times traded together in lockstep, regardless of their positive or negative prospects.

This practice spread from country to country, Cramer said, and it turned stocks into commodities that were traded by contract with futures or exchange-traded funds. But then hedge-fund managers got involved and changed the whole game.

Hedge funds were able to pool such vast amounts of money that they dwarfed individual stocks. They had so much cash that they could buy all the shares available of many companies trading on the market. And because futures markets are much bigger than the regular markets, these funds gravitated toward the former. In the process, they formed a groupthink mentality and started to trade in synch with each other based on the same indicators.

The height of this groupthink occurred in 2008, Cramer said, when a lot of hedge funds bought and sold the same commodities, and did so with borrowed money. When those trades turned out to be wrong, the funds were forced to sell en masse in order to keep from going under. The end result was that the related stocks took a serious hit, and unnecessarily so.

The positive side of this action, though, is that these moves are opportunities. While some stocks deserve to go down, others do not. This kind of activity continues to happen today, including during summer 2011. So don’t buy into the panic, Cramer said, buy the declines. And they will happen again because hedge funds are still trading stocks in the same way.

“The next time you see everything go down at once,” Cramer said, “ask yourself if we might simply be seeing the results of hedge funds gone wild.”

Read on for Cramer's Top Dividend Stocks

Written by Tom Brennan; Edited by Drew Sandholm

Call Cramer: 1-800-743-CNBC

Questions for Cramer? madmoney@cnbc.com

Questions, comments, suggestions for the Mad Money website? madcap@cnbc.com

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