ATLANTA, June 27, 2008 /PRNewswire via COMTEX/ ----Editor's Note: The following white paper was written by Thomas E. Quinn, the chief executive officer and chief investment officer of Atlanta-based CornerCap Investment Counsel.

Over the last few days, the market accelerated its downturn that started last October and is very close to the official bear market marker, down 20%. On Thursday, the subtle drift felt more like a sudden surge, with the S&P 500 Index's declining almost 3%.

When John Bogle was recently asked about a substantial one-day sell-off in the market, he paraphrased Shakespeare's Macbeth, saying that "A day in the movements of the market is like a tale told by an idiot, full of sound and fury, signifying nothing." As we experience market manias over time, it is important that we keep things in perspective; else we will lose our perspective.

While there are clearly dislocations occurring in certain market sectors, the market does not appear overpriced at this time. The S&P 500 Index is trading at a price-to-earnings ratio in the mid-teens, which is in line with historic valuations. For the more speculative short-term investor, these periodic plunges do serve to keep the game more interesting, to weed out the marginal players, and to transfer more wealth from the clients to the service providers on Wall Street.

Moving beyond today's market mess, we believe that a worthwhile perspective can be learned from the meaningful market bubbles and crashes over the last few decades. (See the end of the article for what we consider to be the most relevant crashes and bubbles.) What are the common threads that run through these significant equity market events? What can we learn from the past?

Overconfidence. Rather than a common thread, we would categorize overconfidence as more of a guaranteed component of any crash. We have always been amazed at the ease in which investors can acquire sufficient confidence in whatever is going on and place enormous bets. We have found this greed-based attribute relatively easy to spot, i.e., the 2007 real estate bubble and credit crisis, the 1980 (and current?) oil bubble, and the 2000 tech bubble. The secret to spotting the next foolish market behavior is simply to (1) watch for a really large, well-formed herd that is moving rapidly in lock step and (2) confirm that every other investor out there believes you to be a total fool when you do not join him.

Experts' Models. The experts normalize historic data and create computer-based logic to model market behavior. These models may work 99.9% of the time in their back-testing labs. Some experts (oftentimes academics) are also good salesmen. As their flock of followers grows, their ".1%" probability of failure also grows, moving closer to a certainty than a minuscule probability. The most alluring pied pipers are most likely to lead investors off a dangerous cliff.

Debt Market. We have observed that the debt market is another common thread for market crashes. We had the rising interest rates in 1980 and 1987. We saw the collapse of the Long Term Capital Management Fund in 1989 that was leveraged in Treasury bonds, Russian bonds, and other debt securities. Most recently, we have seen the subprime mortgage market bring havoc to important sectors of the equity market. When interest rates are rising, the perception of long-term inflation is also rising, and unbridled perceptions can move markets in mass.

Leverage. We believe that the overconfidence noted above causes investors to become lax in their standards for making loans and valuing stocks. This optimism seems to attract higher degrees of leverage, both financial leverage and concentration leverage. Over leveraging is the way to make a lot of money. An investor can also lose a lot of money, more money than is invested. When holders of huge concentrations of dollars all try to sell their similar holdings at the same time, they have to form a long line at the exit.

Correlation Risk. Based on daily trading activity, we believe that the hedge funds are the largest and most highly leveraged lump of money in the market. While the strategies employed by these hedge funds differ, some recent market behavior and research studies have indicated that many funds are effectively moving in and out of the same types of holdings. These de facto interconnections will cause major disruptions in the market, such as what we have experienced with the subprime connected securities.

Hedge Funds. All of the above warning signs are common to the hedge funds. A few predictions: More funds will continue to fail. The de-leveraging (i.e., selling) process will be powerful and will affect other hedge funds, resulting in a growing number of failures. These failures will by no means kill the business. For the seller, who is the hedge-fund manager, the upside opportunity (with little downside) for creating personal wealth is too great. For the buyer, there will always be those who want to speculate, regardless of the odds.

 CornerCap's Position 

What has really changed over the last 30 years? Not as much as you might think. We still have long-term investors and short-term speculators. Buffett, Templeton, Bogle, Neff, Lynch, and other great thinkers about the market are saying the same things they have always said.

The next major drop in the market will be driven by some or all of the factors listed in our article. At CornerCap, we may or may not see the drop approaching, but if we do predict it (i.e., the two previous bubbles), we will not know the month or year when it will hit.

Long-term investing is so easy that we hate to make a public admission. You simply need a well-grounded philosophy and discipline that has been proven to perform well over time, a logical process for implementing the philosophy and measuring its disciplined implementation, and the ability to set the appropriate risk/return balance in the marketplace. This is what we have done, what we do now, and what we will continue to do.

Short-term investing is substantially more difficult. These "investors" ensure that Wall Street is highly compensated for funding and managing the games they are enticed to play, and Wall Street is huge and hungry. It is not unlike Vegas. There are some big winners, but the only guaranteed winner is the house account. The aggregation of all of the players is guaranteed to lose.

 Meaningful
   Market Crashes Since 1980 

Oil Bubble (1980) -- This commodity-based bubble proved to be a wonderful opportunity for our pre-CornerCap firm. Our Fundametrics(R) research moved us into the lower multiple energy stocks in time to catch the bubble's upside. In November 1980, with almost every advisor believing that oil was going to $100 a barrel (1980 prices), our research suggested otherwise, and we exited the sector. In December, the energy stocks began a gradual decade-long decline.

Portfolio Insurance (1987) -- This one-day crash occurred 20 years ago, on October 19, 1987. During the original junk bond funded buyout boom, the academics had constructed a product (Portfolio Insurance) that gave the pension funds comfort with their increasingly bullish investments. Even though interest rates and equity valuations were rising during 1987, this "insurance" became a free pass for institutional investors to act recklessly. The academics who designed and marketed this product failed to model the effect accurately when all of the institutional investors tried to pass through the safety hatch at the same time. Following the 36% market free fall, it only took nine months for the market to fully recover. At the time, the current CEO of CornerCap was the senior investment officer at RJR Nabisco, and he was proud of the fact that he was making major equity purchases at the bottom of the one-day crash. Not surprisingly, the CEO of RJR Nabisco did not share the same pride.

Long Term Capital Management (1998) -- LTCM was an early hedge fund driven by a few highly regarded investment academics. At play once again was the overconfidence of the academics with what they considered as an almost "risk free" process. The inordinately leveraged bond-focused fund collapsed in the summer of 1998, threatening the liquidity of the entire market. Similar to 1987, the computer-based trading models helped drive the market down around 20% at the low point, but the Fed jumped in to strong-arm a rescue, and the market quickly recovered. With the growing influence of computer trading models, brief downturns of olden days were quickly turning into severe market routs.

Tech Bubble (2000) -- The academics were important boosters for the late 1990s technology boom, internet extrapolations, and redefinition of the "new economy." Again, we saw the emergence of overconfident investors using leverage and overconcentration to take more risks than was appropriate. Similar to the Oil Bubble, our Fundametrics(R) research steered us away from technology, and we actually realized positive equity returns during the three-year market decline that followed the March 10, 2000 tech peak.

About CornerCap

CornerCap is an independent investment counseling and management firm focused on providing quality investment decisions and the highest level of client service. The firm has been serving clients since 1989, providing investment management services to private clients, institutions, foundations, and endowments. CornerCap serves clients around the globe from its offices in Atlanta, Ga. and Charlotte, N.C. For more information call 404-870-0700 or visit www.cornercap.com .

SOURCE CornerCap Investment Counsel

http://www.cornercap.com
   

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