What Does Greece Mean to You? - John Mauldin's Weekly E-Letter

Always well-written, John Maudlin’s weekly newsletter is a joy to read. This week’s letter should be shared, though. It gives us all a view of the precarious economic moment we now face.

Sat, March 27, 2010 2:13:55 AM

In this issue:
What Does Greece Mean to Me, Dad?
Dear Kids,
Ubiquity, Complexity Theory, and Sandpiles
Fingers of Instability
Washington DC, Albuquerque, and Guy Forsythe

"To trace something unknown back to something known is alleviating, soothing, gratifying and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the first instinct is to eliminate these distressing states. First principle: any explanation is better than none... The cause-creating drive is thus conditioned and excited by the feeling of fear..." Friedrich Nietzsche

"Any explanation is better than none." And the simpler, it seems in the investment game, the better. "The markets went up because oil went down," we are told, except when it went up there was another reason for the movement of the markets. We all intuitively know that things are far more complicated than that. But as Nietzsche noted, dealing with the unknown can be disturbing, so we look for the simple explanation.

"Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brains that make us feel good. We become literally addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important to the chemical release. And thus we look for reasons.

How does an event like a problem in Greece (or elsewhere) affect you, gentle reader? And I mean, affect you down where the rubber hits your road. Not some formula or theory about the velocity of money or the effect of taxes on GDP. That is the question I was posed this week. "I want to understand why you think this is so important," said a friend of Tiffani. So that is what I will attempt to answer in this week's missive, as I write a letter to my kids trying to explain the nearly inexplicable.

But first, let me note to Conversations subscribers that we have posted a Conversation I recently did with Professors Ken Rogoff and Carmen Reinhart, authors of This Time It's Different, which has my vote for most important book of the last few years.

Last week we also posted a Conversation with two noted hedge-fund managers, Kyle Bass of Hayman Advisors (and his staff) here in Dallas and Hugh Hendry of the Eclectica Fund in London. Our discussion centered on what we all think has the potential to be the next Greece, but on a far more serious level.

That got a lot of positive response. Herb wrote, "Wow. What a great discussion. What smart guests, how little BS. Congratulations. It's the best of your Conversations that I've listened to."

And ACK wrote: "Wow!! Just the most important discussion I have been treated to as an investor and fund manager this year or last. Your product is dreadfully underpriced, as it delivers more value and education than almost any other subscription that I have... Thanks so much... This particular conversation was just mind-blowing!"

Actually, we get that last comment almost every issue, as we somehow seem to connect the dots for different listeners. When we started, I promised to do 6-8 a year, and we have already posted 5 timely Conversations in the first 3 months of this year, including my special Biotech Series as well as the Geopolitical Series with George Friedman.

For new readers, Conversations with John Mauldin is my one subscription service. While this letter will always be free, we have created a way for you to "listen in" on my conversations (or read the transcripts) with some of my friends, many of whom you will recognize and some whom you will want to know after you hear our conversations. Basically, I call one or two friends each month and, just as we do at dinner or at meetings, we talk about the issues of the day, back and forth, with give and take and friendly debate. I think you will find it enlightening and thought-provoking and a real contribution to your education as an investor.

And as you can see, I can get some rather interesting people to come to the table. Current subscribers can renew for a deeply discounted $129, and we will extend that price to new subscribers as well. To learn more, go to http://www.johnmauldin.com/newsletters2.html. Click on the Subscribe button, and join me and my friends for some very interesting Conversations. (I know the price says $199 on the site, but for now you will only be charged for $129 – I promise.)

And we are starting a renewal cycle with the subscriptions and have found a small bug in the software we purchased to handle them. Renewals are therefore not instantaneous. It may take a day, and for that we apologize. We are fixing it.

Oh, and by the way, since the Conversation on Japan was so well-received, the next one will be on China. Two brilliant managers (maybe three) with VERY divergent views. I may just toss in a few grenade-type questions and stand back and watch the show. And now on to this week's letter.

What Does Greece Mean to Me, Dad?

Tiffani had been talking with her friends. A lot of them read this letter, and they were asking, "Ok, I get that Greece is a problem. But what does that mean for me here?"

The same day, a friend told me about a conversation she had with her 17-year-old Cal Tech daughter and her daughter's boyfriend, who is also headed to Cal Tech. These are really smart kids, and they were asking her about some of my recent letters. "We understand what's he saying, but we just don't see what it means." (For what it's worth, the boyfriend wants to grow up to be Mohammed El-Erian of PIMCO. Go figure; I just wanted to be Mickey Mantle.)

Twice in one day is a sign, I am sure, so I will try and see if I can explain. And since all my kids must be wondering the same thing, this is kind of letter from Dad to see if I can help them understand why things are not going as well as they would like.

(A little background. I have seven kids, five of whom are adopted. A fairly colorful family, so to speak. Pictures at the end of the letter. Ages almost 16 through 33. Daughter Tiffani runs my business and, except for the youngest boy, they are all out on their own. Four are married or attached. It is not easy to watch them struggle to make ends meet, but Dad is proud. But listening to their stories, and the stories of their friends, help keep me in the real world.)

Dear Kids,

I know what a struggle it has been for most of you, and now three of you have a kid of your own. Expensive little hobbies, aren't they? I know that you read my letter (well, except for Trey) and wonder what it means to you trying to pay your bills. Let me see if I can make a connection from the world of economics to the world of paying your bills. Sadly, what I am going to say is not going to make you feel any better, but reality is what it is. We'll get through it together.

While life looks pretty good for Dad now, when I graduated from seminary in December of 1974 unemployment was at 8%, on its way to 9% a few months later. We lived in a small mobile home, which seemed wonderful at the time. I was proud of it. We scrimped and got by. My first job was a dead end, so I left after a few months. I guess I was lucky that no one would hire me, because I had to figure out how to make it on my own. All I really knew was the printing business I had grown up in, so I started brokering printing. Pretty soon I was doing just direct mail, and then designing direct mail. But there was never enough money. We were still in that mobile home six years later.

And prices were going up like crazy. We had inflation. I remember going to a bank in the late '70s and borrowing money for my business at 18%, so I could buy paper for a job I had sold. Forget about borrowing for a new home or car. All I knew was that I was struggling to make ends meet (with a new kid!). There were a lot of nights where I would wake up at two in the morning with panic attacks about whether I could make payroll or pay bills until someone paid me. I didn't understand that what the Fed and the government were doing was causing high inflation and unemployment.

I had a bank line I used to buy paper with. One day the bank abruptly cancelled that line and demanded their money, which I didn't have – all I had was a warehouse full of paper and a contract that said I had a year to pay for it. The bank didn't care. I told them they would just have to wait. I swear, they actually called my mother and told her they would ruin me if she didn't pay that $10,000 line. She was scared for me (after all, you had to be able to trust your banker) and paid it without asking me. Turned out the bank finally went bankrupt later in the year. They were just desperate and trying anything they could do to get money, so they wouldn't lose everything. They did anyway.

In short, times were not all that good, but we got through it. And now, 35 years later, it seems like déjà vu all over again. Every time we talk it seems like someone we know has lost a job.

And so how do the problems in a small country like Greece make a difference to you? There is a connection, but it's different than the old "hip bone is connected to the thigh bone to the knee bone" thing. It is a lot more complicated. Let's go back to a letter I wrote four years ago, talking about fingers of instability. One of the best analogies your Dad has ever written, according to many of his 1 million friends. So read with me a few pages, and then we'll get back to Greece.

Ubiquity, Complexity Theory, and Sandpiles

We are going to start our explorations with excerpts from a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies. http://www.amazon.com/exec/obidos/ASIN/0609809989/frontlinethou-20

We all had the fun as kids of going to the beach and playing in the sand. Remember taking your plastic buckets and making sandpiles? Slowly pouring the sand into ever-bigger piles, until one side of the pile started an avalanche?

Imagine, Buchanan says, dropping just one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it gains momentum and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld, began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

It was indeed completely chaotic in its unpredictability. Now, let's read these next paragraphs slowly. They are important, as they create a mental image that helps me understand the organization of the financial markets and the world economy.

"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red.

"What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions.

"But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]... In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."

Then they asked themselves, could this phenomenon show up elsewhere? In the earth's crust, triggering earthquakes; in wholesale changes in an ecosystem or a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third-rate paper in Denmark could cause worldwide riots?

Buchanan concludes in his opening chapter, "There are many subtleties and twists in the story ... but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I've mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things.

"At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before."

Now, let's think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the likelihood of an avalanche is 2.14 times as unlikely. We find something similar in earthquakes. In terms of energy, the data indicate that earthquakes simply become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law," or a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game? "... after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into ‘fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind:

"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."

Now let's couple this idea with a few other concepts. First, one of the world's greatest economists (who sadly was never honored with a Nobel), Hyman Minsky, points out that stability leads to instability. The longer a given condition or trend persists (and the more comfortable we get with it), the more dramatic the correction will be when the trend fails. The problem with long-term macroeconomic stability is that it tends to produce highly unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

Relating this to our sandpile, the longer that a critical state builds up in an economy or, in other words, the more fingers of instability that are allowed to develop connections to other fingers of instability, the greater the potential for a serious "avalanche."

And that's exactly what happened in the recent credit crisis. Consumers all through the world's largest economies borrowed money for all sorts of things, because times were good. Home prices would always go up and the stock market was back to its old trick of making 15% a year. And borrowing money was relatively cheap. You could get 2% short-term loans on homes, which seemingly rose in value 15% a year, so why not buy now and sell a few years down the road?

Greed took over. Those risky loans were sold to investors by the tens and hundreds of billions all over the world. And as with all debt sandpiles, the fault lines started to show up. Maybe it was that one loan in Las Vegas that was the critical piece of sand; we don't know, but the avalanche was triggered.

You probably don't remember this, but Dad was writing about the problems with subprime debt way back in 2005 and 2006. But as the problem actually emerged, respected people like Ben Bernanke (the chairman of the Fed) said that the problem was not all that big, and that the fallout would be "contained." (I bet he wishes he could have that statement back!)

But it wasn't contained. It caused banks to realize that what they thought was AAA credit was actually a total loss. And as banks looked at what was on their books, they wondered about their fellow banks. How bad were they? Who knew? Since no one did, they stopped lending to each other. Credit simply froze. They stopped taking each other's letters of credit, and that hurt world trade. Because banks were losing money, they stopped lending to smaller businesses. Commercial paper dried up. All those "safe" off-balance-sheet funds that banks created were now folding. Everyone sold what they could, not what they wanted to, to cover their debts. It was a true panic. Businesses started laying off people, who in turn stopped spending as much.

As you saw from my earlier story about my bank experience, banks may do what unreasonable things when they get into trouble. (Speaking of which, my smallish Texas bank, where I have been for almost 20 years, just cancelled my very modest, unused credit line last month, and told me that letters of credit will not be rewritten without 100% cash against them. Not to worry, Dad is actually in the best shape of his life, business-wise, knock on wood. I hadn't talked personally to a banker in years. When I asked the young clerk on the phone, "What's going on?" he said it was just an order from his director. I switched banks last week, as I can smell a bank in trouble. And I again have a credit line – which I hope not to use.)

But the fact is, we need banks. They are like the arteries in our bodies; they keep the blood (money) flowing. And when our arteries get hard, we can be in danger of heart attacks. And it's going to get worse, as banks are going to lose more money on their commercial real estate loans. Commercial real estate is down some 40% around the country.

There are a lot of books that try to pinpoint the cause of our current crisis. And some make for fun reading, like a good mystery novel. You can blame it on the Fed or the bankers or hedge funds or the government or ratings agencies or any number of culprits.

Let me be a little controversial here. The blame game that is now going on is in many ways way too simplistic. The world system survived all sorts of crises over the recent decades and bounced back. Why is now so different?

Because we are coming to the end of a 60-year debt supercycle. We borrowed (and not just in the US) like there was no tomorrow. And because we were so convinced that all this debt was safe, we leveraged up, borrowing at first 3 and then 5 and then 10 and then as much as 30 times the actual money we had. And we convinced the regulators that it was a good thing. The longer things remained stable, the more convinced we became they would remain that way. The following chart shows how our sandpile ended up. It's not pretty.

I know Dad always say it is never "different," but in a sense this time is really different from all the other crises we have gone through since the Great Depression that your Less-Than-Sainted Granddad used to talk about. What the very important book by professors Reinhart and Rogoff shows is that every debt crisis always ends this way, with the debt having to be paid down or written off or defaulted upon. That part is never different. One way or another, we reduce the debt. And that is a painful process. It means that the economy grows much slower, if at all, during the process.

And while the government is trying to make up the difference for consumers who are trying to (or being forced to) reduce their debt, even governments have limits, as the Greeks are finding out.

If it were not for the fact that we are coming to the closing innings of the debt supercycle, we would already be in a robust recovery. But we are not. And sadly, we have a long way to go with this deleveraging process. It will take years.

You can't borrow your way out of a debt crisis, whether you are a family or a nation. And as too many families are finding out today, if you lose your job you can lose your home. What were once very creditworthy people are now filing for bankruptcy and walking away from homes, as all those subprime loans going bad put homes back onto the market, which caused prices to fall, which caused an entire home-construction industry to collapse, which hurt all sorts of ancillary businesses, which caused more people to lose their jobs and give up their homes, and on and on.

It's all connected. We built a very unstable sandpile and it came crashing down and now we have to dig out from the problem. And the problem was too much debt. It will take years, as banks write off home loans and commercial real estate and more, and we get down to a more reasonable level of debt as a country and as a world.

And here's where I have to deliver the bad news. It seems we did not learn the lessons of this crisis very well. First, we have not fixed the problems that made the crisis so severe. We have not regulated credit default swaps, for instance. And European banks are still highly leveraged.

Why is Greece important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth. And just a few years ago this seemed like a good thing. The rating agencies made Greek debt AAA, and banks could use massive leverage (almost 40 times in some European banks) and buy these bonds and make good money in the process. (Don't ask Dad why people still trust rating agencies. Some things just can't be explained.)

Except, now that Greek debt is risky. Today, it appears there will be some kind of bailout for Greece. But that is just a band-aid on a very serious wound. The crisis will not go away. It will come back, unless the Greeks willingly go into their own Great Depression by slashing their spending and raising taxes to a level that no one in the US could even contemplate. What is being demanded of them is really bad for them, but they did it to themselves.

But those European banks? When that debt goes bad, and it will, they will react to each other just like they did in 2008. Trust will evaporate. Will taxpayers shoulder the burden? Maybe, maybe not. It will be a huge crisis. There are other countries in Europe, like Spain and Portugal, that are almost as bad as Greece. Great Britain is not too far behind.

The European economy is as large as that of the US. We feel it when they go into recessions, for many of our largest companies make a lot of money in Europe. A crisis will also make the euro go down, which reduces corporate profits and makes it harder for us to sell our products into Europe, not to mention compete with European companies for global trade. And that means we all buy less from China, which means they will buy less of our bonds, and on and on go the connections. And it will all make it much harder to start new companies, which are the source of real growth in jobs.

And then in January of 2011 we are going to have the largest tax increase in US history. The research shows that tax increases have a negative 3-times effect on GDP, or the growth of the economy. As I will show in a letter in a few weeks, I think it is likely that the level of tax increases, when combined with the increase in state and local taxes (or the reductions in spending), will be enough to throw us back into recession, even without problems coming from Europe. (And no, Melissa, that is not some Republican research conspiracy. The research was done by Christina Romer, who is Obama's chairperson of the Joint Council of Economic Advisors.)

And sadly, that means even higher unemployment. It means sales at the bar where you work, Melissa, will fall farther as more of your friends lose jobs. And commissions at the electronics store where you work, Chad, will be even lower than the miserable level they're at now. And Henry, it means the hours you work at UPS will be even more difficult to come by. You are smart to be looking for more part-time work. Abbi and Amanda? People may eat out a little less, and your fellow workers will all want more hours. And Trey? Greece has little to do with the fact that you do not do your homework on time.

And this next time, we won't be able to fight the recession with even greater debt and lower interest rates, as we did this last time. Rates are as low as they can go, and this week the bond market is showing that it does not like the massive borrowing the US is engaged in. It is worried about the possibility of "Greece R Us."

Bond markets require confidence above all else. If Greece defaults, then how far away is Spain or Japan? What makes the US so different, if we do not control our debt? As Reinhart and Rogoff show, when confidence goes, the end is very near. And it always comes faster than anyone expects.

The good news? We will get through this. We pulled through some rough times as a nation in the '70s. No one, in 2020, is going to want to go back to the good old days of 2010, as the amazing innovations in medicine and other technologies will have made life so much better. You guys are going to live a very long time (and I hope I get a few extra years to enjoy those grandkids as well!). In 1975 we did not know where the new jobs would come from. It was fairly bleak. But the jobs did come, as they will once again.

The even better news? You guys are young, still babies, really. Hell, I didn't have a good year income-wise until I was in my mid-30s, and that was an accident (I literally won a cellular telephone lottery). And it has not always been smooth since then, as you know. But we get through bad stuff. That is what we do as a family and as the larger family of our nation and world.

So, what's the final message? Do what you are doing. Work hard, save, watch your spending, and think about whether your job is the right one if we have another recession. Pay attention to how profitable the company you work for is, and make yourself their most important worker. And know that things will get better. The 2020s are going to be one very cool time, as we shrug off the ending of the debt supercycle and hit the reset button. And remember, Dad is proud of you and loves you very much.

Good times. I can feel the band warming up, so I am going to depart. Have a great week.

Your trust me, we will get through this analyst,
John Mauldin
mailto:johnmauldin@FrontLineThoughts.com

Copyright 2010 John Mauldin. All Rights Reserved
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Portfolio management – an alternative

Modern portfolio management theory emphasizes risk management through diversification. Simply put, investors are advised to spread their investments across sectors and asset classes, offsetting risk among component weightings. However, this rigid system of diversification avoids market timing aspects of risk and often exposes investors to drawdowns that could be avoided with an approach that better adapts to the market environment.

There are few money managers that employ more aggressive diversification strategies. One upstart investment firm is focused on systematic trading and has caught my eye – Acorn Global Investments Inc. of Oakville, Ontario. A recent paper explains Acorn’s approach:

Systematic Trading: Diversification Done Right

Stock picks in the security industry

A fragile balance between global economic recovery, sovereign debt problems, and potentially threatening commodity inflation is the thematic market headline challenging investors early in 2010. However, the stock market is also reminding investors that security issues are a major business opportunity in our time. Threats to our economic security remain the primary driver of capital scurrying between asset classes, but a big challenge for economic well-being in our age is securing commerce - and the population - from threats big and small. Almost a decade after the history-altering terrorist act now referred to as 9/11 stewards of the global economy remain anxious to find systems and technological solutions to security risk. Judging by the performance of many of the stocks that represent this effort to make the world a safer place, the market is doing its job of accepting this challenge.

Although companies in the security industry range across a broad scope of service and systems – from typical security services to high tech applications of screening and warning devices – this loose grouping of enterprises devoted to reducing risks of harmful acts, as well as natural disasters, is worth watching. Recent stock market trends show that investors know the stakes are big, and that economic dislocation and crisis is a tremendous cost for failure to defend against security risk. Some of these security industry stocks are currently delivering trend trading opportunities.

One of the best performing stocks on the Toronto Stock Exchange since the market bottom almost a year ago has been Garda World Security Corp. (GW-T). This Montreal-based security services firm has a worldwide presence, but the 2008 recession pummelled its shares to a penny stock from much loftier heights. The stock took off last year, though, and became Stock Trends Bullish in early June after its initial rally more than tripled the share price from its 2009 open. Since its rebirth as a bullish stock GW has doubled in value again and is now scaling new 52-week highs as its shares approach $12. The share price would have to double again to challenge the highs prior to the stock’s 2007 perch, but trend investors can look toward an advance to the $15 area as an immediate objective.

 

OSI Systems, Inc. (OSIS-Q), a security scanning systems provider, saw its stock break out in early 2010. Although it has been Stock Trends Bullish for the past three quarters, OSIS upward sloping 13-week moving average is now helping the stock regain a footing above $30 (US). If the share price manages to push ahead of its January high, eclipsing $33, investors will look positively toward adding to their positions.

 

ICx Technologies (ICXT-Q) develops sensors and surveillance systems. Its stock, along with the shares of identity security firm IntelliCheck Mobilisa, Inc. (IDN-A), had a huge breakout in the short trading week before the New Year - the holiday attempted airline bombing a blunt reminder of the powerful lever terrorist acts have on these stocks. Share prices in both companies have since slipped back to their 13-week moving average trend line and are trading only lightly now. However, investors can again look at this as another launching pad.

Another bullish trending stock, American Science & Engineering Inc. (ASEI-Q), is currently trading at its 13-week moving average trend line and could also rally to its January high. The shares of this x-ray inspection systems firm would add in excess of 10 per cent on that move.

Analogic Corp. (ALOG-Q) makes explosive detection equipment, but its stock has been somewhat of a dud since its bullish breakout in the first quarter of 2009. For the past 11 months the stock has been in a trading range, struggling to top $40 and slipping back to the $34 area. Currently the shares trade at the ceiling of the range - $42 – and could provide a cue for buyers to pick up the stock if it breaks out of the long term trading range.

Other stocks that deserve attention include L1-Identity Solutions, Inc. (ID-N), maker of biometric identity devices, L-3 Communications Holdings (LLL-N), an intelligence and surveillance systems provider, and Cogent, Inc. (COGT-Q) a name behind fingerprint identification systems. Shares of L-3 Communications rallied off trend line support a month ago and are now making new 52-week highs. L1-Identity’s stock is a current Stock Trends Bullish Crossover (signalling that the 13-week moving average trend line has crossed above the 40-week moving average trend line. Cogent will also be a Stock Trends Bullish Crossover soon.

Security stocks not currently sharing in the positive price trends of their peers include Magal Security Systems Ltd. (MAGS-Q) (computerized security systems), FLIR Systems Inc. (FLIR-Q) (thermal imaging and broadcast camera systems), and Optelecom-NKF, Inc. (OPTC-Q) (advanced video surveillance). There may be other security-related stocks not mentioned here, but surely investors should look favourably on the opportunities in this important growth industry.

Emerging markets slipping below trend

The market’s date with a correction is approaching. Whether that correction amounts to a short-term setback or an expiry of bull market trend that started ten months ago, investor anxiety ratchets up with each down day recorded in global stock markets. This week’s drop in stock prices challenges the bullish price trends that have propelled global markets in the last two quarters, with emerging and European markets taking the biggest slap in the face. Many of the exchange traded funds representing these markets are in, or in danger of, turning Stock Trends Weak Bullish – a signal that should alert investors to re-evaluate their position.

Drops in the prices of a number of BRIC funds, including the SPDR BRIC 40 ETF (BIK-N), iShares MSCI BRIC ETF (BKF-N), Claymore BNY Mellon BRIC ETF (EEB-N) and the Toronto Stock Exchange-listed Claymore BRIC ETF (CBQ-T) are tripping trend alerts. All slipped over 5 per cent on the week by the end of Thursday’s trading, falling below the trend line support of the 13-week moving average. Funds invested in European countries also shared in that decline. Although Canadian equities dropped significantly this week with the materials sector, only gold stocks are currently in a Stock Trends Weak Bullish trend. This retreat in emerging markets, as well as resource equities, hardly arrives unexpectedly – but investors should be concerned about whether this is the beginning of a more serious correction. Is this time to take money off the table in global markets? Or is this a new opportunity to increase exposure to commodity and emerging market equities?

The monetary condition that has re-inflated these equity classes is plainly stated: negative real interest rates. Cheap money is always the source of asset bubbles, and the equity rally that ignited from the depths of a global recession owes a great deal to the immense amount of liquidity pumped into financial markets. However, eventually this excess must come to an end. Markets have spent the last few months trying to figure out when that time will come. A recent retreat in the price of gold, a tentative oil market, and the seeds of a relatively revived U.S. dollar are possible signals that a low short-term interest rate policy (oh heck, it’s a zero-interest rate policy in the U.S.) may end sooner than we think. If the punch bowl is taken away, commodity stocks and emerging markets will not rebound from the current weakness.

If U.S. interest rate changes are due, investors will be quickest to hit the sell button on emerging markets. The BRIC and Latin American funds that have dropped in recent sessions, in particular, deserve attention. The iShares MSCI Brazil ETF (EWZ-N), for instance, dropped to the $68 level this week, a mark it also fell to at the end of October when a chill hit the global reflation trade. Although a 15 per cent rebound from here would entice short-term commodity bulls, this Latin American fund, as well as others, are now below a supporting trend line – unlike the autumn retreat. A rally off this level is possible, but investors should be concerned about this trend line violation.

Some trading slack still left

Technical analysts like to look backwards. They look at chart patterns earnestly – hoping to decode the signs of change in a price level. Looking back to predict the future is the modus operandi of the market technician. Some like to say that “this time things are different”, that the forces acting on the market today are far different from the forces that moved the market decades ago. Most often, though, history proves to be a sage advisor. In truth, the market is evolving – like the world it reflects – and there are new and complicating variables that make it difficult, maybe impossible, for even the most revered oracle to see clearly through the fog. One changed factor that has made a difference in the markets is the tremendous expansion of capital and trading. Compared to the liquidity of today, the markets of a generation ago were homespun, almost quaint.

The total market capitalization of the Toronto Stock Exchange – itself just a tiny component of a vastly grown global equity market – has increased from about $100-billion in the mid-1960s to over $1.7-trillion currently. But the size of the market, both locally and globally, implies a new variable only in so much as that growth in capital corresponds to an increasing propensity to trade. Trading is what creates price changes in securities. It is the force of change on valuations – and it expands market volatility. More trading demands better information, better pricing discipline, and more efficient markets.

Given the latest market meltdown that last statement may have you in stitches – we seem to move from one bubble to the next. However, trading expansion is undeniable and consequential to the movement of prices. On the TSX average daily trading volume is up almost 678% in the last 15-years. But average daily transactions are up over 3,179%! Clearly, a new type of investor has come to the fore. From a growing number of actively managed accounts under the wing of institutional portfolio advisors to the small retail investor trading from home computers, there is a tremendous force of energy fuelling stock price movements. The character of that trading shows that market timing activity – a heightened intensity of trading – in the plummeting average traded value in recent decades. Average traded value on the TSX was about $50,000 fifteen years ago – now it’s one-fifth that level.

The market downturn last year stalled out the growth in transactions. Looking back to the market bust of 2000 the TSX showed a similar decline and plateau of transactions. Not until five years later, did the number of weekly trades begin a new trajectory. Notably, the current market rally that has added 50% to the S&P/TSX Composite Index has been accompanied by diminished average weekly transactions. At the March market low the TSX recorded about 4.4-million weekly trades. Average weekly transactions over the last three months numbered only 3.7-million – a drop of 17%. Average weekly volume of shares traded, however, is only 4% below the March price level low. And although shares are transacting at a better rate now than when the S&P/TSX Composite Index peaked in Q2 of 2008 (up 20%), that growth is less than the growth of the volume of shares traded (up 23%).

What does the slipping transaction growth rate in the current rally suggest? Perhaps it is telling us that that despite worries that the market is overextended, the retail investor has not yet arrived at the party. There may be more room for either a continued uptrend or at least a flattening of the market trend as opposed to a severe pullback in the coming quarters. A rapid increase in the number of transactions is concurrent with a selloff, to be sure, but it can also occur in advance of that selloff – at a market price level peak. In recent market price level peaks the rate of transaction growth was significantly higher than the rate of volume of shares growth. Although this is consistent with the long-term trend described already, the current market conditions seem to offer relatively favourable support of a bullish outlook.

Metal Mining edge

For all the angst about the collapsing U.S. dollar in the past few months, the greenback is now trading essentially at the same level it did before the financial crisis imploded capital markets and sent economies worldwide into recession. Although many financial institutions are far from sound, investors have taken apocalyptical risk out of the equation and have shifted back to their usual modus operandi of maximizing relative returns on capital. However, faith in the store of value represented in the international reserve currency is highly strained, and capital flows show the lost confidence could send the dollar spiralling further. This fear is currently driving commodity markets and the gold sector. The question for equity investors is how best to play this bet against the greenback?

Currency and commodity exchange traded funds are direct investments that small investors can now trade. There are funds, too, that specialize in markets of commodity strength – which would include Canadian equities – or non-dollar denominated markets, especially Euro-zone. Emerging markets, too, are a magnet for capital wary of the declining U.S. currency. Even the stocks of multinational U.S. corporations, like Coca-Cola Co. (KO-N) and Caterpillar Inc. (CAT-N), that derive much or most of their earnings from foreign markets are considered dollar-hedging investments.

In this monetary environment Canadian investors are again sitting in a sweet spot thanks to the heavy commodity bias of our market. The mining sector is outperforming the broad TSX market by 26 per cent since mid-summer and is not yet showing signs of relinquishing its leadership role. Gold stocks are comparatively unspectacular – up by no better than the 11 per cent that the S&P/TSX Composite Index has advanced over the period. However, “black gold” producers – the energy sector – are showing some relative strength, outperforming the market by 7 per cent. Investors should start to look at the relative movement of these sector plays on the falling U.S. dollar, which fell another five per cent against a basket of currencies represented in the U.S. Dollar Index (DXY-I) over the past three months. In times of dollar instability there are appreciable but varying effects on the stocks of the producers of both hard commodities and oil.

During the last Stock Trends Bearish trend of the U.S. Dollar Index from the summer of 2006 to the trembling of the financial crisis two year later metal mining stocks were largely in a strong bullish trend. Gold stocks, though, were in a flat trend throughout the period. So, too, with energy stocks – although they rallied strongly when crude oil prices peaked and put a stranglehold on global economic growth. Investors can learn from the last stint of dollar devaluation: commodity inflation can be largely benign until it hits energy prices. The current market stock market performances of these sectors suggest a similar scenario. Investors can continue to weight in the bullish mining sector, but beware the return of triple digit crude oil prices.

While the relationship of gold and oil is typically a commodity focal point of investors worried about currency fluctuations, metal mining stocks are also showing the relative value of other commodity hard assets, like copper and iron ore. Generally, these industrial-use commodities do not have the allure of traditional stores of value found in precious metals, and move cyclically with the global economy. Certainly, the strength of the mining sector is a strong vote of confidence in the economic recovery likely in place. But investors are also responding to dollar weakness by bidding up these assets even further. Mining stocks will continue to attract investment flows while the greenback remains in a bearish trend.

The relative performance of metal mining stocks versus energy stocks took an about face at the end of last year in the pit of the financial crisis. This shows that investors started to favour these industrial commodities over the bleaker energy fundamentals. In fact, mining stocks have performed much better than gold stocks since the March stock market bottom. Charts of the price movement of the S&P/TSX Mining Index versus the price movement of the S&P/TSX Energy Index show just how favourably investors have fared in hard commodities relative to investors weighted in another dollar denominated commodity – crude oil. When compared on the same basis, investors in gold stocks have not benefited as well during this period of dollar weakness.

Shippers leaving port?

A notable lagging group in the stock market’s recovery has been marine shippers. While the rest of the transport sector shows the wheels of commerce once again turning, the shares of shippers have been stuck at port, victims of excess capacity and uncertainty about global shipping demand. The Baltic Dry Index, a measure of international shipping prices for dry bulk cargoes, has recovered from its 2008 low, but still remains 78% shy of its high in the summer of 2008. Although this price weakness reveals that marine transporters are still in a difficult position, investors seem to be awakening to a hope that the demand part of the equation is improving for the shippers. After months under water, some of these shipping stocks are floating again.

The Claymore/Delta Global Shipping Index (SEA-N) exchange traded fund tracks the performance of marine shippers, both dry bulk, container ships, and tankers. Although lacking the trading volume and price momentum that fuelled a rally in the second quarter, the ETF is Stock Trends Bullish. Of particular interest, though, is the dry bulk shipping stocks. The share prices of carriers of crude oil and liquefied natural gas have been comparatively buoyed – the stock of Teekay Corp (TK-N), for example, is up 37% in the last three months and is hitting new 52-week highs. A resurgence of the depressed dry bulk shippers (transporters of raw materials like iron ore, coal, and grain) and container ships (generally carrying consumer and industrial finished goods) - is a signal that the global economic recovery is real, and not an illusion of economic wishful thinking. Judging by a nascent recovery of some of these stocks, investors are gradually betting that reality will be catching up with our prayers.

Although it is too early to declare a solid shift in trend for the group, the appearance of certain dry bulk and container shippers in the Stock Trends filters for Weak Bearish stocks, as well as strong recent price moves suggests that investors should keep an eye on the progress of their developing trends. Among stocks currently alerting of trend changes are Seaspan Corp. (SSW-N), TBS International Ltd. (TBSI-Q), Paragon Shipping Inc. (PRGN-Q), and DryShips, Inc. (DRYS-Q). Recent price moves by Diana Shipping Inc. (DSX-N), Danos Corp (DAC-N), and diversified shipper Frontline Ltd. (FRO-N) reflect a sign of hope, too. International Shipholding Corp. (ISH-N), Overseas Shipbuilding Group (OSG-N), Navios Maritime Holdings Inc. (NM-N), and Safe Bulkers, Inc. (SB-N) have been trending bullish since mid-summer – all adding to the encouraging signal coming from the shippers.

Most of these names may be unfamiliar to the average investor. However, they represent an important bellwether of the vitality of the global economy. Although the precariously fragile U.S. economy factors heavily in a clean bill of health, the global economy and international trade to emerging markets will be a key indicator of demand factors that will continue to drive the materials and industrial sectors. The same factors that drive up the price of raw materials will eventually make its way to filling the shipping capacity that has dragged on maritime haulers since the 2008 global collapse. When the Baltic Dry Index and the stocks of dry bulk shippers start to trend bullish investors can begin to rest more comfortably.

Feelin’ healthy

Lost amid the percolating anticipation investors have placed in the market’s advance is the quiet rehabilitation of health care stocks. Gold and oil stocks are under increasing pressure to bust loose, a trader’s dream – but investors should take a good look at the reassuring trends in a defensive sector that has its own building steam. U.S. health care stocks have been trending positively with the rest of the market since the March market bottom, despite the polarizing political debate about health care insurance in America. Only the financial sector, itself coming off life-support, has performed better than healthcare stocks over the past three months. The health sector promises leverage with its stable of biotech and pharmaceutical stocks, yet generally offers investors defensive cover in the event of a market reversal. Obamacare or not, the stock market is grabbing on to some traditional health care anchors.

During the bear market of last year the S&P Healthcare Index showed its relative price performance over the broad market through the last half of 2008 until the market bottomed in March of this year. When the financials took the market in a tailspin, health care stocks sank with the rest of the market – just not so badly. That is the desired outcome for a defensive sector: relative price performance. But now pharmaceutical stocks, north and south of the border, are showing a performance premium in a bull market. Almost all of the big cap pharma names are in Stock Trends Bullish trends and outpacing the S&P 500 over the recent summer months. Even with its massive acquisition of Schering-Plough Corp. (NYSE:SGP) in the works, Merck & Co. (NYSE:MRK) is up 18% since early June; and Pfizer Inc. (NYSE:PFE) is up 13%, a tidy vote of market confidence that was good cover for the company’s recently announced details of its $2.3-billion settlement of criminal charges. Investors can feel good about pharma’s solid footing in the current market environment.

The Health Care Select Sector SPDR (NYSE:XLV) represents the 13.4% weighting of health care stocks in the S&P 500 and is the most actively traded exchange traded fund in the sector. The next most transacted health care portfolio is the Pharmaceutical HOLDRs (PPH-N), which generally has less than 10% of the number of transactions XLV logs in every week. There are other funds specialized in biotech, medical devices, and healthy services, as well as leveraged Rydex health care ETFs, but XLV is the liquid center of investors’ broad exposure to the group. However, four key big cap pharma stocks account for 34% of the weighting of the fund – Johnson & Johnson (NYSE:JNJ), Pfizer, Merck, and Wyeth (NYSE:WYE). Wyeth is the best performer of the group – hitting new 52-week highs at the end of August – but all of these important stocks are currently in bullish trends, with both JNJ and MRK poised to rally off trend line support.

Stock Trends Bullish since early July, XLV has been quietly advancing along its price channel, making new 2009 highs during the summer as the U.S. health care political debate heated up. The ETF’s price pattern could see the sector add another 10% in the third quarter, especially as Congress works toward clearing uncertainty about health care insurance reform. The bullish trend of the sector indicates that investors are betting on calmer heads prevailing, and are looking for further upside if the broad market continues to advance. If a market correction is instead forthcoming, health care stocks should still be a good play.

Position sizing - fixed investments

Most novice investors, and many experienced ones, do not develop a sophisticated money management trading plan. Last week this column highlighted the importance of an exit strategy, of limiting losses in individual trades, as a trading practice that improves investment returns over the long-term. But there is another question that should be asked when developing a trading strategy: how much should be invested in each position? Many investors know that they will not be so fortunate to have maximized investment in winning positions, and minimized investment in losing positions. Few will ever be so charmed. However, investors can attempt to optimize their money management so that they can most benefit from their trading strategy. Adjusting the amount invested in each position, within the limits of available capital, can affect your portfolio returns.

The Stock Trends TSX Portfolio trading strategy, a model portfolio that has been active for over 15 years, operates on a fixed investment premise. All 440 positions taken were bought for the same transaction cost ($10,000). Whether a large cap stock valued at $25, or a small cap stock trading at $2.50, all trades were limited to the same dollar value exposure. The implication of these equal investments is greater risk (and profits) on lower priced stocks. How would the overall investment return of this portfolio record change if the invested amount for each trade was variable, instead of fixed? This is the kind of question active investors should ask of their own money management.

If the trading history of the Stock Trends TSX trading strategy is replicated with either random or variable investment costs on individual positions, the investment returns of the portfolio change. A random quantity of shares (between 200 and 2,000, for example) invested shows us that portfolio returns can be considerably different. Although the average amount invested in this example remains close to the $10,000 invested in the actual model portfolio, a random sequence of shares invested (correspondingly changing the invested amount to random costs) produces a range of portfolio returns that differ considerably from the actual results.

While the fixed investment strategy of the Stock Trends TSX Portfolio has produced an annualized 39% return on average investment, the random invested amounts for the same trading record results in a range of annual returns from a low of 23% to as high as 59%. Remember, the individual trades only differ by the amount invested - prices and order of trades remain the same – and so does the individual percentage return on each trade. Only the dollar value of the gains and losses varies. Where increased invested capital in winning trades and decreased invested capital in losing trades more favourably reflect the best outcomes, the portfolio returns improve.

The reason for these variable results becomes more apparent when the trading record of the portfolio is adjusted instead to be a fixed number of shares. If we again keep the average amount invested over the 400 positions close to $10,000, but always trade the same number of shares – say 1,000, for example - the return over the entire period is comparable to the actual portfolio result, again about 39% annualized return on average invested capital. However, dropping the number of shares traded to 500, thereby halving the average amount invested on individual trades, reduces annualized portfolio returns to 32%. Doubling the average amount invested by buying 2,000 shares in each position, though, increases annual return over the period to 43%. Notably, annual returns maximized at 46% regardless of how high the average invested amount is adjusted to.

The result of the fixed number of shares example occurs because the varying amount invested is in relation to the price of the stock. Although the example of the random investments highlights that overall portfolio returns can be optimized if the trader is somehow weighted heavily in winning trades, this is an unlikely probability. An investor would have to know in advance which trades were going to be the big winners and increase the invested capital. More reasonable expectations are needed. In reality, we are never certain which stocks are going to be the best performers.

Varying investment amounts can improve portfolio returns based on the price of stocks, but only to a certain level. For that reason, Stock Trends maintains that it is best to use a fixed investment rule. However, that may not be the best case scenario for all strategies, and investors can look at their own trading records to see how their results would change with different money management rules. Position sizing is an under-appreciated aspect of trading.

A detailed trading record of the Stock Trends TSX Portfolio is found at http://www.stocktrends.ca/stonline/stp-tsx1.php

Money management and an exit strategy

Investors serious about succeeding on their own need to learn an important lesson about trading first: stock picking is not the most crucial aspect of being a successful trader. Money management and a trading plan will determine investment returns over extended periods. Knowing how much to invest and how to take a loss, more than always picking winning stocks, are the skills that mark most professional traders. Of course, every trader wants to imagine they are going to be right most of the time, that they have a special gift for picking stocks. In truth, that expectation is unrealistic. In fact, novice investors learn quickly that being wrong – and taking losses – comes a lot easier than they imagined. For the unprepared, this awakening is brutal.

If taking losses is such a big part of trading, how does anyone walk away from the market ahead of the game? A surprising revelation to the uninformed is that some of the best traders in the world are making a handsome living by picking losing stocks most of the time. They perform this magic by limiting their losses and maximizing their gains. In other words, their trading plan allows them to manage a string of relatively small losses before irregular big winning trades make up for the pain of an unforgiving market. When a trader’s account takes a dip – called a drawdown – he or she stays committed to their plan, largely because it forces the trader to respond quickly to a trade gone bad. This demands an almost inhuman capacity to set aside one’s emotions – our ego, our fears – and to pull the sell trigger. No insisting that the market is wrong, that it will get things right and see things your way soon. Instead, a good trading plan insists on a prescribed exit strategy before the trade is entered.

Stock Trends provides a good example of how a trading plan can help turn the reality of a miserly market into appreciable investment returns. Recall that Stock Trends is a system of categorizing stocks based on a moving average system of analysis. It is a rigid system, simple in its definitions, but consistent in its comprehensive application to the North American Stock market. For over 16-years the Stock Trends indicators have been published for stocks listed on the Toronto Stock Exchange. This has been an interesting testing ground for applying a mechanical trading system – a model portfolio derived from a trading plan with prescribed buying and selling triggers based on Stock Trends indicators and technical triggers. The Stock Trends TSX Portfolio has been filtering the weekly market activity and applying the same trading strategy since 1993 with positive results – a 39% annualized return on average investment.

The trading record for this strategy provides important insight applicable to every investor’s approach to the market. Over the almost 16-years of trading 440 stock positions have been taken. Each position is limited to a fixed investment of $10,000, with the buy criteria specified by Stock Trends’ Bullish Crossover trend indicator as well as minimum price and volume requirements. The important aspect of the buy strategy is the limited exposure – one assumes trading equity of at least $50,000. The second part of this attempt to limit exposure to losses is found in the exit strategy. One of the sell triggers is a stop loss provision (8% trailing stop on the highest closing price). Although the exit strategy is based on weekly trading, and has some implied exposure to abrupt daily stock movements, it has been relatively successful in managing trading losses.

In line with expected results, the Stock Trends TSX Portfolio trading record shows that only 40% of positions taken were winning trades. It turns this middling success rate into positive returns by keeping losing positions relatively contained. The average loss of losing positions is 10% (all results include trade commissions). The average gain of winning trades approaches 30%. Most revealing is the distribution of returns on these trades. The vast majority of returns are clustered between -10% and 10%, with the accompanying graph showing the skewness of the distribution curve. This should be the typical expectation of a trader: relatively few big winners compensate for the more numerous in-field hits.

Obviously, a big factor in every trading system is the order of the trades. Excessively long strings of trading losses challenge every investor, and can wipe out many unprepared investors. Stock Trends Portfolio loss runs have reached a high of 12 consecutive trading losses, however most losing strings end at four. The maximum drawdown on trading equity was 35% (in a period between late 1998 to mid-1999), not particularly great, but still better than the 45% drawdown that the TSX delivered after the 2000 peak – a crushing collapse that buy-and-hold investors did not recover from until five years later. The recent bear market hurt, too – another 49% drawdown!

Investors, big and small, should have a trading plan in place that helps remove some of the self-defeating aspects of our personal profile which handicap success. Dealing with trading losses is difficult, but learning how to act systematically with them will protect an investor from developing costly emotional attachments to individual trades. Keeping a detailed trading record is an important part of understanding how to make your trading plan work for you. As the Stock Trends model  portfolio illustrates, you do not have to be a perfect stock picker to  succeed in the market.

The market is not a level playing field, nor should it be

There has been growing debate about institutional trading practices, with politicians and the public again demonizing moneyed players on Wall Street. These practices are facilitated by technology that has made speed of execution an advantageous and profitable backroom for dealing securities microseconds before they become available to the broader trading public. A recent article by MSN’s Michael Brush explains this high speed trading, flash trading, and black pools. Coming to the defence of these practices are investment professionals like Donald Luskin and Chris Hynes, co-authors of a Wall Street Journal op-ed piece that fuelled expected wrath from investors who smell rats on Wall Street again.

However, the anger of the public on these technologies and alternate markets is simply another form of populism. The notion of equality and a level playing field in the markets is misguided. Markets operate at many levels, from small investors with sleepy mutual funds held for years at their bank to highly capitalized banks with multi-million dollar trades executed many times a day. Markets now operate 24-hours a day in a broad range of securities and assets. The key growth for these tremendously important  capital markets is liquidity – the ability of the industry to bring in capital to individual markets and spur trading. Without liquidity the world’s markets would collapse into the dark ages.

How could there be a level playing field in the high stakes game of investing? Without expanding institutional liquidity the markets would become extremely volatile. Without technology driving the growth of institutional liquidity the capital stock does not grow.

Too often critics of the market – markets where the best rise to the top based on human and capital resources – cry foul because their utopian desire for equality is transgressed. But the beauty of a free market is that it expands the pie, and gives every player a chance at growing assets. However, not every player is entitled to the same resources. Risk and reward are the underlying determinants of the playing field. The more you put at risk, the more resources – human and capital – demanded. Wall Street represents the the best, the brightest players in the market. It is capitalized accordingly. This has always been the case.

It is important that ordinary investors recognize the benefits of free markets and the way resources are allocated by pricing mechanisms. Yes, it would be great if everyone had access to the same computers, the same capital, the same acumen. But that vision is a corruption of the human condition, it is the disabling framework of socialism.

Every day trader knows that the propensity of making profits does not improve with the frequency of trading. High speed trading and back room dealing does not improve the prospect of success any more for the players, either. Every buyer must find a seller. Every winner meets a loser. That is the market.

The market should not be viewed as some egalitarian model. It is not. Instead, it is a mechanism for growth where every player has a role and an opportunity to build their assets commensurate with their human and capital resources. Fairness is not a single level playing field.  If we try to make it so, we will handicap growth and violate our liberty.

Washington Stock Exchange

The stock market is supposed to be the bastion of the free market – ownership of private enterprise swaying to the demand and supply of private capital. However, judging by recent trading activity that model seems strangely defunct. As last week’s trading record shows, quasi-government enterprises are the stocks most attracting investors. Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), American International Group (NYSE:AIG), as well as government-beholden Citigroup (NYSE:C), and Bank of America (NYSE:BAC) are notably at the top of the market’s most actively traded stocks. The market seems intent on speculating that this public-private contract has a positive outcome. Whatever the result, this is where the trading action is.

Duh! … another zero level thinker

The following is an excerpt from a speech by James Montier of Société Générale in London on the problems with the Efficient Market Hypothesis (EMH). (thanks to John Mauldin).

Montier shares again his 2004 replication of Keynes’ beauty contest, and shows us just how difficult it is to outsmart a market. A humorous example of the Nash equilibrium at work in an imperfect world.

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The undue focus upon benchmark and relative performance also leads Homo Ovinus to engage in Keynes' beauty contest. As Keynes wrote:

"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the price being awarded to the competitor whose choice most nearly corresponds to the average preference of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees"

This game can be easily replicated by asking people to pick a number between 0 and 100, and telling them the winner will be the person who picks the number closest to two-thirds the average number picked. The chart below shows the results from the largest incidence of the game that I have played - in fact the third largest game ever played, and the only one played purely among professional investors.

The highest possible correct answer is 67. To go for 67 you have to believe that every other muppet in the known universe has just gone for 100. The fact we got a whole raft of responses above 67 is more than slightly alarming.

You can see spikes which represent various levels of thinking. The spike at fifty reflects what we (somewhat rudely) call level zero thinkers. They are the investment equivalent of Homer Simpson, 0, 100, duh 50! Not a vast amount of cognitive effort expended here!

There is a spike at 33 - of those who expect everyone else in the world to be Homer. There's a spike at 22, again those who obviously think everyone else is at 33. As you can see there is also a spike at zero. Here we find all the economists, game theorists and mathematicians of the world. They are the only people trained to solve these problems backwards. And indeed the only stable Nash equilibrium is zero (two-thirds of zero is still zero). However, it is only the 'correct' answer when everyone chooses zero.

The final noticeable spike is at one. These are economists who have (mistakenly...) been invited to one dinner party (economists only ever get invited to one dinner party). They have gone out into the world and realised the rest of the world doesn't think like them. So they try to estimate the scale of irrationality. However, they end up suffering the curse of knowledge (once you know the true answer, you tend to anchor to it). In this game, which is fairly typical, the average number picked was 26, giving a two-thirds average of 17. Just three people out of more than 1000 picked the number 17.

I play this game to try to illustrate just how hard it is to be just one step ahead of everyone else - to get in before everyone else, and get out before everyone else. Yet despite this fact, it seems to be that this is exactly what a large number of investors spend their time doing.

by James Montier of Société Générale

Position sizing

Most of us enter the stock market burdened with faulty biases and misguided conceptions about how to succeed in our trading program. We think that we can beat the market by being smarter than the market. We think that we will establish a winning method of stock selection by way of superior information, that the road to profits will be paved by our consistent ability to pick winners. In short, we enter the market with an emotional commitment to our own judgement. Unfortunately, it is this highly individualized bias that is our ultimate nemesis. Experienced traders know that the key to market success has less to do with a uniquely developed style and method of picking stocks, and more to do with a disciplined execution of sensible and rigid money management principles.

These “judgement biases” are described meaningfully by Van K. Tharp, in his significant contribution to the business of trading, Trade your Way to Financial Freedom (McGraw-Hill,1999). Our trading systems are handicapped by the fact that we typically trade our beliefs about the market, we accept conventional representations of information, and adopt trading practices that undermine trading success by inadequately protecting against actual risk. Further, we consistently and foolishly bet against the odds and succumb to undisciplined approaches to trading.

What precisely are we talking about here? Let us assume that a trader has developed a trading system that generates a positive expectancy – a profitable trading strategy that either has a superior winning percentage (% of winning trades) or a superior profit factor (where the profits of winning trades far exceeds the losses of losing trades). There remains a variable that will, in fact, determine the actual long-term profitability and risk factor that results: the position size.

An often-cited experiment by Ralph Vince, who has been an seminal author of important trading analysis treatises (Portfolio Management Formulas and The Mathematics of Money Management), tested the gambling performance of 40 Ph.D’s on a simple computer game with a 60% chance of winning. Each were given $1,000 in play money and instructed to bet however much money they wished (or could) over 100 trials. The end result was that only two made money.

The undoing of this group of individuals, in fact, is the undoing of many traders: we tend to bet more when we think we are going to be right (or need to be right), and bet less when we are less certain of the outcome. In other words, our emotions have dictated our risk. If the 40 Ph.D’s had religiously accepted the mathematical probability that a constant bet of $10 over 100 turns would have resulted in a 20% gain. Yet, these individuals were inclined to vary their bets (risk) in hopes of achieving better results.

There are varying methods of determining what is an optimal position size. Some are related to drawdown. Some are related to other statistical variables that a given trading system produces. But for general purposes we can simply recognize some basic common sense principles. First, in order to trade properly one must remove emotional attachment to a position. The only way this can be done is if there is enough available trading capital to allow for actual risk. You cannot trade effectively with inadequate capital. Second, traders must limit risk in a quantifiable fashion. For the purposes of retail traders like the majority of Stock Trends followers, a benchmark of 1-2% of available trading equity should be at risk in each trading position (Where the risk is defined by a quantifiable measure. For example, the average loss per trade plus one standard deviation.)
Obviously, position size will be determined by available capital, so the money management guidelines will be predicated by sufficient funds available. Finally, constant position sizing will enable a trading system to minimize the hazardous effects of our inherent, emotionally charged biases.

The best analysis tools I’ve seen that provides position size guidance is the m3 Money Management Modeler, designed by trader Brian Ault of Fulcrum Shift Trading. Brian’s platform looks at trading as a probability assignment, taking essential input variables to determine HOW MUCH to trade on given positions – either stocks or options. Traders, advanced and novice, should learn how to incorporate this kind of risk analysis in their trading strategies. A good trading plan should factor  in probability analysis.

[Most of this is post is a reprint of a Stock Trends Weekly Reporter editorial from 2003]

Golden time to take out some insurance

If investors had a crystal ball that could map the market course ahead, they would want to know the answer to one critical question: whither the greenback? Although monetary excess and fiscal strains appear aligned for a humbling slide in the value of the U.S. dollar, an uncertain economic recovery and the timing of a dollar downdraft has the market conflicted. A picture of this angst is found in the gold sector, where dollar bears typically find a comforting lair. Gold stocks have been trending flat for months, lost in a trading range amid the broad market’s rally off its March low. The strength of emerging markets – many up over 30% in the last three months - may reflect some of the money flows that would have gravitated toward precious metals instead of dollar assets. However, as the global stock market rally becomes vulnerable to a pullback, investors should anticipate an approaching watershed moment for bullion and prepare for bullish price momentum in gold stocks.

After rallying from an October low of 150 to a February peak of 350, the S&P/TSX Global Gold Index  has since bounced between its 2009 high and long-term 40-week moving average trend line. The 13-week average price level, at 315, seems to be the magnetic center for the gold index while base metal mining stocks rocket ahead at an impressive clip. A continued consolidation at this level suggests that a rally back to 350 could be ahead for the gold stock index – especially if bullion prices gain traction during this summer stock market rally.

The price of gold hit a two-month high early this week, dabbling with the $970 level. Investors should be keying on the metal over the coming weeks - advances in bullion prices that stretch toward the $1,000 high water mark will bring appreciable upside opportunity for investors weighted in gold stocks. A rally to this psychological barrier will be an important technical signal for the investment landscape, surely providing investors with enticing odds for doubling down on inflationary pressures built into the U.S. monetary structure. Tremendous liquidity has been pumped into the banking system and few market participants have full confidence that the Federal Reserve has the political will to deliver a winning exit strategy if the U.S. employment picture remains sour. Investors enjoying the market ride this summer would do well to hedge their bet on a prolonged bullish trend for equities with increased exposure to the gold sector.

The iShares S&P/TSX Global Gold Fund (TSX:XGD) is currently categorized as Stock Trends Weak Bullish – the exchange traded fund has been dancing along its trend line support for a month. Trading activity has been stable but uninspired through the last quarter, but now would be a good entry point for investors. The fund’s price pattern formed over the past four months is the technical framework for a trade. The triangular continuation pattern – share price has gradually converged toward its current mean at $19.60 - suggests that a breakout move toward the $21 level would be bullish. Sharing this chart pattern are big cap gold stocks Agnico-Eagle Mines (TSX:AEM) and Goldcorp (TSX:G), both showing leadership for the group.

Some specific gold plays are already showing strong bullish trends and tipping toward better things ahead for the rest of the group. Leading small cap gold stocks include Golden Star Resources (TSX:GSC), West Timmins Mining (TSX:WTM), Queenston Mining (TSX:QMI), and Lake Shore Gold (TSX:LSG) – all shining performers. If investors get spooked by a sharp correction when the summer stock market rally reaches exhaustion, these and other precious metal stocks will be fruitful insurance policies.

Good news from Media stocks

A sign of an improving economy is the bullish turn of media stocks. The Stock Trends Picks of the Week report includes a number of them this week, including McClatchy Co (NYSE:MNI), and the Journal Communications (NYSE:JRN) – both breakout stocks advancing on high volume.  Media General (NYSE:MEG) and the New York Times (NYSE:NYT) also have made surprising moves and appear in the report. Google Inc. (NASDAQ:GOOG) is in a Stock Trends Bullish trend and is poised to rally off trend line support. Expect continued advances from Liberty Media (NASDAQ:LMDIA), as well.

Investors can play the sector with the Powershares Dynamic Media ETF (NYSE:PBS).