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The Market, Investments, And
The ‘Efficient Market Theory’

by Joseph Dancy, LSGI Advisors, Inc. | October 9, 2008


In what will rank as the largest regulatory failure in modern history last month was the worst month for the financial sector since the Great Depression. Even Warren Buffett admitted he had problems figuring out the value to place on credit default swaps, collateralized debt obligations, and other derivatives held as ‘assets’ at many of these firms.

Last month a half dozen companies in the financial sector that were large cap stocks become microcap firms—all in the space of a month. None of these shrunken firms make our screens or pass our due diligence. A.I.G., Lehman Brothers, Washington Mutual, Wachovia, Freddie Mac, Fannie Mae, Silver State Bank and a number of other financial firms saw their market value plummet – with their shareholders losing $500 billion in market value over the last 12 months.

These firms have no ‘assets in the ground’ and manufacture nothing of value. Their valuation in many cases depends on computer models to estimate the worth of their financially engineered ‘assets’. In many markets few of these instruments are actively traded, so we have no accurate ‘market clearing’ price.

The wild decline in value of these well known firms is an illustration of how inefficient the allocation of capital is in the equity markets. And it is an illustration of the problems that arise when there is a grossly negligent lack of regulation and regulatory oversight by key governmental agencies. Keep in mind the large cap sector of the market is considered by experts as the ‘most efficient’ part of the market.

In light of developments last month in the financial sector those who invest in the grossly inefficient and volatile micro and small cap sector have to expect volatility—but the inefficiencies create opportunities to find undervalued and attractive firms. These smaller firms generally have business models and strategies that are easily understood, analyzed, and company assets that can be valued with some degree of certainty.

If the global markets can be stabilized, and if the monetary authorities continue to ease to address the global credit issues, we think small firms will perform well as they have historically in easing cycles. Keep in mind that the systemic risk in the markets is much larger than many expected – but then again global attention of the global bankers, politicians, and regulators is now focused on the urgent necessity of ‘correcting’ the problem.

Historical studies indicate that when the Federal Reserve is easing credit the small capitalization sector tends to outperform the rest of the market. Current economic conditions are unique in that the credit contraction is especially severe, potentially representing a systemic risk to the entire economy.

1If the Fed is successful in easing credit, especially if other national banks join in the easing cycle, we would expect small firms to resume their tendency to outperform (chart data from Gerald R. Jensen, Robert R. Johnson, and Jeffrey M. Mercer, authors of “The Role of Monetary Policy in Investment Management”).

2When we look at the recent performance of larger companies versus smaller firms we find that as the Federal Reserve has eased over the last year smaller firms have indeed started to outperform
(represented by the downward trend of the large cap S&P 500 Index/small cap S&P 600 Index ratio in the 5-year chart (source: Hays Advisory)).

And keep in mind last month U.S. mutual fund investors pulled out record amounts of money from mutual funds in a wild orgy of redemptions —$74.5 billion—triple the previous record set in September, 2001.

Almost all fund families experienced major net redemptions. These liquidations will require the funds to sell assets—sometimes quite a few assets - which will add to downward pressure on stock prices. Add on margin calls to hedge funds and financial institutions and we have a short term selling frenzy, with prices falling to levels not seen in decades.

3Due to the extreme volatility and investor concerns, some traditional indicators have become very bullish. Hays Advisory reprinted a chart from showing that cash in money market funds could buy 27% of the S&P 500 – the highest level in 24 years. The last peak in 2003 was roughly 22% - and resulted in a vigorous rally (chart courtesy Hays Advisory).

Mark Dodson of Hays Advisory also presented the following chart last month on investor sentiment showing a reading of 163%, with the following commentary:

‘. . . a reading of 150% on this indicator has been a solidly bullish signal historically. On average the market is up more than 18% over the next 12 months when hitting this level. Remember, that’s an average number. With the power of mean reversion in markets, we believe that hitting this level not once but FIVE times within the last 12 months winds the rubber band tighter each time. . . . From the downside protection point, when the AAII bears/bulls hits [exceeds] 150%, the market has advanced 97.5% of the time over the next 12 months. For those two instances where the market was down over the next 12 months, it was down an average of 3.5%, giving you a good idea of how well this indicator gives you a signal at or near market bottoms. [emphasis supplied]


If the global economic system does not experience a systemic meltdown, we agree with Dodson’s comments that we are close to a market bottom.

© 2008 Joseph Dancy

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Joseph Dancy, Adjunct Professor, Oil & Gas Law, SMU School of Law, Advisor, LSGI Market Letter | Joseph Dancy's Book Reviews | E-mail

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