In today’s Outside the Box, my good friend George Gilder, the well-known techno-utopian, attempts with some success to turn economics on its ear. “The economy is not chiefly an incentive system,” he asserts, “it is an information system.” And information, truly understood, is about the introduction of novelty, or “surprise,” into a system. In the case of the economy, it’s about invention and entrepreneurship. The new information that is injected gets converted into knowledge; and thus, says George, it is accumulated knowledge, rather than money or material, that constitutes true wealth.

And thus the economy is driven not so much by powerful people and institutions wielding the levers of the economic machine as it is by the ever-increasing power of information and knowledge. Economists and the governments they work for often appear to prefer a deterministic, no-surprises (and too-big-to-fail) economy, but that way lies economic stagnation. If determinism worked, socialism would have thrived.

Knowledge is centrifugal: it’s dispersed in people’s heads, and that has never been more true than in the Age of the Internet. And it is this universal distribution of knowledge which feeds back to the economy through the creative insights and entrepreneurial efforts of people worldwide that constitutes our chief hope for economic growth in the era opening up before us, where the limits of monetary manipulation and material extraction are becoming painfully apparent.

Here is a telling sentence from George:

Whether fueled by debt or seized by taxation, government spending in economic “stimulus” packages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.

The writing is on the wall: either we reinvent ourselves and our global economy, or the noise that is obviously building in the system will overwhelm the creation and transmission of knowledge, and the great human quest for the democratization of wealth will fail. But, as George says, “[C]apitalism is not a system of equilibrium; it is an engine of disruption and invention…. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.” So we do have plenty of grounds for hope.

For the young among my readers, George Gilder wrote the seminal work Wealth and Poverty(which has been recently updated) back in the early ’80s, selling over 1 million copies and influencing a generation. He was Ronald Reagan’s most-quoted living author. He has written many books since then, but his latest book, Knowledge and Power, is in my opinion even more important.

When you combine Gilder’s work with Nassim Taleb’s Antifragility, along with the ideas that appeared in the recent Outside the Box piece by Charles Gave on the natural rate of interest, you can begin to get a real sense of why the design of the current monetary system is so flawed. Gilder’s work is foundational to that understanding. We have given our central banks a mandate far outside their actual capabilities: we’ve made them responsible for employment. With their limited tools, they have set about to improve employment but are disseminating corruption in their communications to the markets, in ways they neither intend nor understand. The framework that dominates the thinking of current central bankers simply does not encompass the new paradigm being advanced by Gilder, Taleb, Gave, and others.

Once you grasp the futility of the current structure, you can begin to make sense of the direction of the economy and understand how to position portfolios for continuing periods of exceptional volatility. In one of the great human ironies, the drive to reduce the fragility of the system in fact creates an even more fragile system, until we have a Minsky Moment on steroids. But that’s a topic for yet another book. I have talked George into writing a summary of Knowledge and Power for today OTB, but it does no more than skim the surface. His books should be included in your fall reading.

George and I have spent many hours talking about new technologies and their implications. Longtime readers know I have a deep fascination with technology and creativity. I have recently been able to get my great friend Pat Cox (who knows more about such things than I have forgotten) to agree to come and write for Mauldin Economics. We will shortly be launching a newsletter focused on technologies that have the potential to transform our society — and ways to invest in them. Pat Cox should be a familiar name to readers of Outside the Box, and I can’t tell you how thrilled I am to be able to work together with him, exploring the fascinating new world that is being created all around us.

I am still thinking through the implications of what I saw on my recent trip to North Dakota. There was just so much positive energy and potential everywhere that it makes you want to come up with ways to transfer that process in every area of the economy. Ironically, if it was up to the federal government as currently comprised, the Bakken oil play wouldn’t exist. It is messy and chaotic and not at all capable of being directed by a central planner. In short, it is massively successful, without one dollar of government money funding the individual businesses. There are no Solyndras in North Dakota. I’m sure there are lots of small failures here and there, but they haven’t cost taxpayers any equity money.

It is a busy week for me here in Dallas, with lots of meetings and research and writing piling on top of one another, plus family, gym, and other personal commitments. Tomorrow I get to have lunch with my friend Kyle Bass and go from there to spend a few hours with Dr. Woody Brock, who is in town for a speech. However much time I have with Kyle or Woody is not enough, as there are just too many ideas to capture in a few hours. But we all talk fast and try to get in as much as possible. I live for these times.

I think I’ll hit the send button and turn back to my reading. I just had a huge database of over 500 city pension plans pop into my inbox, and that is going to capture my attention for the next few hours. You gotta love having readers who can access just about anything and get it to you. When I come up for air I’ll write about what I learned this week. And speaking of weeks, you have a good one.

Your finding out that yoga hurts analyst,

John Mauldin, Editor
Outside the Box
JohnMauldin@2000wave.com

The Need for a New Economics

By George Gilder

Why is it that so many Americans seem to believe that government spending, fueled by debt or taxes, can drive economic growth and wealth creation? Why do they believe that low interest rates, enforced by the Federal Reserve, can somehow spur business and investment? Why do they imagine that money and consumer demand impel the economy forward?

The reasons, I believe, are rooted in an economic confusion between knowledge and power. Many economists believe that growth is impelled by the exercise of power, represented by money creation and by government spending and guarantees. By manipulating the so-called “levers of the economic machine,” government power can enlarge demand, inducing businesses to invest and consumers to spend. This process is seen to generate the demand that fuels economic growth.

These images of the economy of power are part of the very creation story of economics in an era of new machines and sources of energy. The first economic models were explicitly based on the dynamics of the steam engine then impelling the industrial revolution. Isaac Newton’s physical “system of the world” became Adam Smith’s “great machine” of the economy, an equilibrium engine transforming coal and steam into economic growth and progress.

Exploring technology investments over recent decades, however, I found myself preoccupied less with sources of power than with webs of knowledge in a field of study called Information Theory. On one level this theory was merely a science of networks and computers. Its implications, however, would change our deepest concepts of the nature of wealth. It would show that wealth is not money or power or demand. It is essentially the accumulation of knowledge.

Information theory effectively began with Kurt Godel’s demonstration in 1930 that all logical systems, including mathematics, are intrinsically incomplete and depend on axioms that they cannot prove. This epochal finding is often obscured by elaborate explanations of the intricate mathematics he used to prove it. But as John Von Neumann in his audience was first to recognize, Godel’s proof put an end to the idea of the universe, or the economy, as a mechanism. Godel’s proof, as he himself understood, implied the existence of autonomous creation.

Godel’s proof led directly to the invention by Alan Turing of a universal generic computer, a so-called Turing machine. By this abstract conception, which became the foundation for all computer science, Turing showed that no mechanistic computer system could be complete and consistent.  Turing concluded that all logical systems were intrinsically oracular.

Computers could not be Smithian “great machines” or Newtonian “systems of the world.” They inexorably relied upon human programmers or oracles and could not transcend their creators. As Turing wrote, he could not specify what these oracles would do. All he could say was that “they could not be machines.” In a computer, they are programmers. In an economy, they are entrepreneurs.

In 1948 a rambunctiously creative engineer, Claude Shannon, from Bell Labs and MIT, translated Godel’s and Turing’s findings into a set of technical concepts for gauging the capacity of communications channels to bear information.

Shannon resolved that all information is most essentially surprise. Unless messages are unexpected they do not convey new information. An orderly and predictable mechanism, such as a Newtonian system of the world or Smithian great machine, embodies or generates no new information.

Studying information theory for decades in my exploration of technology, I finally found the resolution to the enigmas that currently afflict most economic thought. A capitalist economy is chiefly an information system, not a mechanistic incentive system. Wealth is the accumulation of knowledge. As Thomas Sowell declared in 1971: All economic transactions are exchanges of differential knowledge, which is dispersed in human minds around the globe. Knowledge is processed information, which is gauged by its news or surprise.

Surprise is also a measure of freedom and criterion of creativity. It is gauged by the freedom of choice of the sender of a message, which Shannon termed “entropy.” The more numerous the possible messages that can be sent, the more uncertainty at the other end about what message was sent and thus the more information there is in the actual message when it is received.

In Knowledge and Power, I sum up information theory as the treatment of human communications or creations as transmissions down a channel, whether a wire or the world, in the presence of the power of noise, with the outcome measured by its “news” or surprise, defined as entropy and consummated as knowledge.

Since these communications or creations can be business plans or experiments, information theory supplies the foundation for an economics driven not by equilibrium and order but by surprises of enterprise that yield knowledge and wealth.

Information theory requires that such a process be experimental and its results be falsifiable. The businesses conducting entrepreneurial experiments must be allowed to fail or go bankrupt. Otherwise there is no yield of knowledge and thus no production of wealth. Wealth does not consist in material capital that can be appropriated by the greedy or the government but in learning processes and knowledge creations that can only thrive in freedom.

After all, the Neanderthal in his cave had all the material resources and physical appetites that we have today. The difference between our own wealth and Stone Age poverty is not an efflorescence of self-interest but the progress of learning, accomplished by entrepreneurs conducting falsifiable experiments of enterprise.

The enabling theory of telecommunications and the internet, information theory offered me a path to a new economics that could place the surprising creations of entrepreneurs and innovators at the very center of the system rather than patching them in from the outside as “exogenous” inputs. It also showed that knowledge is not merely a source of wealth; it is wealth.

Summing up the new economics of information are ten key insights:

1) The economy is not chiefly an incentive system. It is an information system.
2) Information is the opposite of order or equilibrium. Capitalist economies are not equilibrium systems but dynamic domains of entrepreneurial experiment yielding practical and falsifiable knowledge.
3) Material is conserved, as physics declares. Only knowledge accumulates. All economic wealth and progress is based on the expansion of knowledge.
4) Knowledge is centrifugal, dispersed in people’s heads. Economic advance depends on a similar dispersal of the power of capital, overcoming the centripetal forces of government.
5) Creativity, the source of new knowledge, always comes as a surprise to us. If it didn’t, socialism would work. Mimicking physics, economists seek determinism and thus erroneously banish surprise.
6) Interference between the conduit and the contents of a communications system is called noise. Noise makes it impossible to differentiate the signal from the channel and thus reduces the transmission of information and the growth of knowledge.
7) To bear high entropy (surprising) creations takes a low entropy carrier (no surprises) whether the electromagnetic spectrum, guaranteed by the speed of light, or property rights and the rule of law enforced by constitutional government.
8) Money should be a low entropy carrier for creative ventures. A volatile market of gyrating currencies and grasping governments shrinks the horizons of the economy and reduces it to high frequency trading and arbitrage in a hypertrophy of finance.
9) Wall Street wants volatility for rapid trading, with the downsides protected by government. Main Street and Silicon Valley want monetary stability so they can make long term commitments with the upsides protected by law.
10) GDP growth is fraudulent when it is mostly government spending valued retrospectively at cost and thus shielded from the knowledgeable judgments of consumers oriented toward the future. Whether fueled by debt or seized by taxation, government spending in economic “stimulus” packages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.
11) Analogous to average temperature in thermodynamics, the real interest rate represents the average returns expected across an economy. Analogous to entropy, profit or loss represent the surprising or unexpected outcomes. Manipulated interest rates obfuscate the signals of real entrepreneurial opportunity and drive the economy toward meaningless trading and arbitrage.
12) Knowledge is the aim of enterprise and the source of wealth. It transcends the motivations of its own pursuit. Separate the knowledge from the power to apply it and the economy fails.  

The information theory of capitalism answers many questions that afflict established economics. No business guaranteed by the government is capitalist. Guarantees destroy knowledge and wealth by eliminating the precondition of falsifiability. Unless entrepreneurial ideas can fail or businesses go bankrupt, they cannot succeed in creating new knowledge and wealth. Epitomized by heavily subsidized and guaranteed leviathans, such as Goldman Sachs, Archer Daniels Midland, Harvard and Fanny Mae, the crisis of economics today is crony statism.

The message of a knowledge economy is optimistic. As Jude Wanniski wrote, “Growth comes not from dollars in people’s pockets but from ideas in their heads.” Capitalism is a noosphere, a domain of mind. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.

As experience after World War II when US government spending dropped 61 percent in two years, in Chile in the 1970s when the number of state companies dropped from over 500 to under 25, in Israel and New Zealand in the 1980s when their economies were massively privatized almost over-night, and in Eastern Europe and China in the 1990s, and even in Sweden and Canada in recent years, economic conditions can change overnight when power is dispersed and the surprises of human creativity are released.

Perhaps the most powerful demonstration that wealth is essentially knowledge came in the rapid post world war II revival of the German and Japanese economies. Nearly devoid of material resources, these countries had undergone the nearly complete destruction of their physical plant and equipment. As revealed by decades of experience with unsuccessful ministrations of foreign aid, the mere transfer of financial and political power is impotent to create wealth without the knowledge and creativity of entrepreneurs.

Information Theory is a foundation for revitalizing all the arts and sciences, from physics and biology to mathematics and philosophy. All are transformed by a recognition that information is not order but disorder. The universe is not a great machine that is inexorably grinding down all human pretenses of uniqueness and free will. It is a domain of creativity in the image of a creator.

In the same way, capitalism is not a system of equilibrium; it is an engine of disruption and invention. All economic growth and human civilization stem from the surprises of creativity and the growth of knowledge in a domain of constitutional order.

The great mathematician Gregory Chaitin, inventor of algorithmic information theory, explains that to capture the surprising information in any social, economic, or biological science requires a new mathematics of creativity imported from the world of computers. He writes: “Life is plastic, creative! How can we build this out of static, eternal, perfect mathematics? We shall use post-modern math, the mathematics that comes after Godel, 1931, and Turing, 1936, open not closed math, the math of creativity…”

Entropy is a measure of surprise, disorder, randomness, noise, disequilibrium, and complexity. It is a measure of freedom of choice. Its economic fruits are creativity and profit. Its opposites are predictability, order, low complexity, determinism, equilibrium, and tyranny.

Predictability and order are not spontaneous and cannot be left to an invisible hand. It takes a low-entropy carrier (no surprises) to bear high-entropy information (full of surprisal). In capitalism, the predictable carriers are the rule of law, the maintenance of order, the defense of property rights, the reliability and restraint of regulation, the transparency of accounts, the stability of money, the discipline and futurity of family life, and a level of taxation commensurate with a modest and predictable role of government. These low entropy carriers bear all our bounties of surprising wealth and progress.

Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting http://www.mauldineconomics.com.

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All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Average SFD prices drop after oil spikes:

City Charts HERE

VANCOUVER average single family detached prices in August 2013 ticked up 0.3% M/M but remain 13.3% ($141,100) below their peak set last April 2012 (Vancouver Chart). Vancouver combined residential sales although up 52.6% from last year’s drubbing are down 14.6% M/M (Scorecard) as we head into leaky condo season. Average strata units continue to trade at 3Q 2007 prices and as with SFDs, strata townhouse and condo sales dropped 8% and 16% M/M. Prime location inventory remains static (see the Bubble Deflator)

If you are thinking of buying a Vancouver Condo as an Investment, see my Vancouver Condo Yield Case Study and now that you have the August data, where do you think Vancouver SFD prices will be one year hence? VOTE HERE.
 
CALGARY average detached house prices in August 2013 met with more resistance and ticked down another 1.5% (Calgary Chart) and down 2% from the June peak (Plunge-O-Meter). Strata unit prices split with Townhouse prices up 1.3% M/M and condo prices down 1.4% M/M. Combined residential sales slumped 3.2% M/M and inventory levels remain deeply red (Scorecard) as migrant workers and flood victims compete for housing. Alberta remains a different country with respect to record high earnings and immigration.

The sentiment in Calgary is the least bearish (33% bears to bulls) of the 3 markets polled with only 22% of the survey thinking Calgary SFD prices will be 20% lower in 12 months. What do you think? VOTE HERE.

EDMONTON average detached house prices in August 2013 ticked up 1.5% M/M (Canada Chart) and townhouse and condo prices also increased 1.5% and 2.1% M/M but the joy was all happening on mostly double digit drops in M/M sales (Scorecard). Bidding has yet to break the May 2007 peak SFD price (Plunge-O-Meter) which remains like Calgary 2% below the high.
 
TORONTO average detached house prices for the GTA in August 2013 dropped another 1.4% M/M and are 6.1% ($41,266) below the trifecta breakout highs set in May (Toronto Chart). Combined residential sales are off 11.4% M/M with average SFD sales leading the way down 12% M/M. The gap between Vancouver and Toronto housing prices (Vancouver vs Toronto) widened to 45% more expensive in Vancouver. The GTA may have appeal to the HNWI as a “safe” haven but the media does not rate Toronto as investment grade.

Polled sentiment here continues to suggest that prices will be down another 20% in 12 months. What do you think? VOTE HERE.
 
OTTAWA average detached house prices are not available, instead the chart on this site reflects Ottawa’s average combined residential prices. OREB’s report is sparse and opaque and the CMHC, records for Ottawa inventory remain one month lagging. In August 2013 Ottawa combined residential prices dropped 3.1% M/M (Scorecard) and remain 6.2% below the peak price set in April (Plunge-O-Meter).

MONTREAL median (not average) detached house prices in August 2013 ticked back up 0.7% M/M to the June 2013 record price peak (Canada Chart). SFD prices are range bound held in by negative sales dropping 13.2% M/M and down 0.4% Y/Y. The joy came in with condo sales up 5.5% M/M and up 8.9% Y/Y and condo prices rose 1.8% M/M and 3.3% Y/Y (Scorecard). In the 2011 Census, Montreal added 6.4% more dwelling units while only adding 5.2% more people. There is no shortage of housing, but there is a shortage of earnings; the Province of Quebec ranks 6th in Canada’s 10 provinces for earnings and printed an unemployment rate of 7.7% in May (0.4% above Ontario’s).

Ballsy residential flippers may make faster money in recovering U.S. housing market than in Canada

Real estate expert Ozzie Jurock will host a Real Estate Power WeekendSept. 28-29 in Vancouver.

There are many areas in Western Canada – northern British Columbia is a prime example – where I believe residential investors can make money. But, if you aspire to be a real estate flipper, you are perhaps better off aiming for fast money in the U.S. than in Canada.

Some U.S markets – particularly parts of Florida hit hard during the 2008 crash – have seen price hikes as high as 240 per cent in the past year. In Canada the overall price increase for a detached house from June 2012 to June 2013 was 3.2 per cent, and not all markets fared that well. The price a typical condominium in the City of Vancouver is the same now as it was a year ago, and up just 2.5 per cent in the past six months – the time frame for buying and selling that often defines an aggressive flip.

The U.S. on the other hand should lead the lead the world in residential price appreciation for the next 12 months. The Gobal Economic Research Survey from Scotiabank picks the U.S. as the only western country to see strong residential price gains this year, with forecasts for a 7 per cent increase from 2012.

Some U.S. centres are seeing rocketing price appreciation – and a lot of flippers.

A recent Realtytrac survey shows that the U.S. posted 136,184 detached-house flips – where a home is purchased and re-sold within six months – in the first half of 2013, up 19 per cent from a year earlier and up 74 per cent from the first half of 2011.

The average U.S. real estate investor made an average gross profit of $18,391 on single-family home flips in the first half of the year – a 9 per cent gross return on the initial purchase price. That was up 246 per cent from an average gross return of $5,321 in the first half of 2012 and an average loss of $13,206 in the first half of 2011.

Out of the 100 markets analyzed for the Realtytrac survey, flipping was on the rise in more than two-thirds of them. And some of the strongest flipping markets are not where most people would think (see chart).

Source: RealtyTrac (realtytrac.com) Based on single-detached houses bought and sold within 6 months this year.

* Includes Metro area anchored by this city.

SHORT SALES

Many Canadian investors are tantalized by U.S. “short sale” properties, and they can offer exceptional prices. But they are also a challenge for flippers because of the time it takes to buy and sell them.

Short sales seem like such smoking deals, don’t they? And since these very cheap homes are listed on the Multiple Listing System (MLS), they must be real, mustn’t they? Well, yes, they are listed on a type of MLS (or realtor.com) and the prices quoted are cheap, but it ends there.

I have made offers on 15 U.S. short sales, but have only closed on four of them. They were great deals but also required renovations from $4,000 to $12,000, and it took months to have my offer accepted.

A short sale is a method for a U.S. realtor to obtain interest and offers in a property. The realtor does that by putting up a ridiculous price. Say a home sold for $200,000 three years ago. Well, the realtor puts on a short sale at $45,000. The owner – likely owing the full $200,000 (in the U.S. there were tens of thousands of properties financed at 100 per cent to 125 per cent of value) – does not care, since he/she gets nothing anyhow.

You come along and quickly realize two things:

1. there’s often no financing available; and
2. just because it seems listed at that price, this doesn’t mean the bank will write off the outstanding balance over $45,000.

So you make the offer – all cash – and then you wait. And wait.

Nothing happens in 90 out of 100 cases. But, once in a while, you get a short sale accepted. So, patience and making a lot of offers is the norm for the budding investor.

When making offers, however, note:

• you must submit “proof of funds” from your bank within 48 hours to the bank having the “short sale.” If you can’t do it … don’t bother offering … they will not bother getting back to you;
• properties are sold “as is” and you will need to sign a multi-page document designed to give you all the liability and the bank and former owner none; and
• if you keep the property for less then a year, you cannot claim capital gains (you must own it longer than one year to do so).

Should you bother with U.S. short sales? Yes, go ahead. Just don’t fall in love with a property because less than one in four offers will get through the process. Note also that the market is now attracting multiple offers on well-priced short sales.

From the Western Investor, September 2013

Other articles by Ozzie Jurock:

B.C. investors would be wise to scout three Prairie provinces for future cash flow and appreciation 

Real profits with real land 

West Will Be Best 

Ozzie Jurock is a Vancouver-based real estate investor and publisher of the Jurock Real Estate Insider. He is a contributor in Donald Trump’s book, The Best Real Estate Advice I Ever Received. Reach Ozzie at oz@jurock.com or ozziejurock.com.

In this week’s issue:

• Weekly Commentary
• Strategy of the Week
• Stocks That Meet The Featured Strategy

Stockscores Market Minutes Video
This week, I discuss why you should stick with the long term trend and avoid doubt. Watch it on YouTube by clicking here.

As a trader, how you judge success will have an effect on how you approach the market. Define success incorrectly and you may doom yourself to failure before you ever make a trade. I think unrealistic expectations are a major reason why most people cannot make it as traders. I want to help by showing you how to judge performance and what your expectations should be.

Conventional wisdom leads most to judge success using percentage gain over a time period. This seems to make a lot of sense but it has problems over time. Anyone can get lucky in the relative short term, making them think that they are smart because the market hands them some nice returns. However, the market cycles and if you fail to catch one of the strong up cycles that lets everyone be a winner, you will probably lose it all.

Risk management needs to be part of your criteria for judging success.

It is also important to recognize that the stock market is extremely hard to beat and it is nearly impossible to know what one individual stock will do. With good strategy testing, you can judge what a set of rules will achieve over a large number of trades and use that as your gauge.

Therefore, it is dangerous to judge success over a small number of trades.

A strategy’s potential is measured by its expected value. A strategy that is wrong 90% of the time can still be a great money maker if it makes a lot when it is right. With the same logic, there are strategies that are almost always right but which still lose money because the gainers are outweighed by the losers.

So, do not judge success the way you judge performance on a test, it is about how much you make when you are right versus how much you lose when you are wrong.

Each trade does not have an equal weighting in the measure of overall success. In my trading, I find that I have lots of small winners and small losers that tend to balance each other out. However, it is the occasional big winners that serve as the source of most of the profits.

You have to be patient to let the big winners happen.

Let’s know go through an example of how a trading strategy might work.

Suppose you have a set of rules which, after exhaustive testing, has the following characteristics:

Right 70% of the time, wrong 30% of the time
When it is right, the average profit is two times the average loss
The most common profit is one times the average loss
Once in ten trades, there is a profit that is five or more times the average loss

How would unrealistic expectations destroy the potential of this strategy?

What would happen if the trader expected to never be wrong and, as a result, hung on to his losers until they became winners? Since some trades will never be winners, this would mean he would have much larger losers than the disciplined trader who used stop loss points and planned his losses. Instead of having an average reward for risk of two to one, it might be one to two.

What would happen if the trader judged her performance one trade at a time? With each win – elation. With each loss – despair. This emotional rollercoaster would affect their ability to make the right trading decisions and eventually the trading rules would be broken. The trader would fall apart.

What would happen to the trader who did not understand the expected value of their trading strategy? They would likely fail to limit downside and maximize upside. They would think it was good to make a certain amount of money on a trade rather than judge their success by how much reward they earned for the risk that they took. In time, they would be broke.

Finally, what would happen to the trader who failed to let the big trades happen? Since the majority of their profits come from a minority of their trades, the strategy that they tested and found to be profitable would fail to be so in real trading. The emotional desire to lock in fast profits rather than let the winners run would turn them in to traders with a high success rate but not a lot of profits.

Change how you judge success so that you can approach the market with the mindset of the winning trader. This may contribute more to your success than your ability to pick the right stocks.

A good approach to finding winning stocks is to look for sectors that are showing strength and then look inside those sectors for stocks leading the way. I like to look for Sectors that have been oversold but are showing signs of a turn; I do this each week by looking through about 1400 Exchange Traded Funds to see where there is strength that stands out.

For the past few weeks, I have noticed that money is coming in to the Rare Earth sector. This is a small sliver of the mining market but important because of their use in cell phones. The ETF for this group is REMX, the chart is below.

1. REMX
REMX broke its long term downward trend line early in September after the formation of a rising bottom. This is a typical chart pattern set up that comes at the turning point of a downward trend in to an upward trend. I think it is very early stage of a turnaround where the probability of success is still relatively low but the upside potential is much more significant here than if you wait for the turnaround to develop further.

2. T.RES
T.RES, REE has been doing very well over the past four days, I think it is due for a few days of profit taking so consider a pullback an opportunity to enter with a better reward for risk. This is a longer term trade that may require patience early as the market takes time to catch on to the optimism that is building.

References

• Get the Stockscore on any of over 20,000 North American stocks.
• Background on the theories used by Stockscores.
• Strategies that can help you find new opportunities.
• Scan the market using extensive filter criteria.
• Build a portfolio of stocks and view a slide show of their charts.
• See which sectors are leading the market, and their components.

Disclaimer
This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don’t consider buying or selling any stock without conducting your own due diligence

One unfortunate habit that we commonly see with investors is the tendency to look to short-term market activity for investment guidance. As human beings, most of us are hardwired to defer judgement to the will of the group or at least question our own judgement when the consensus is against us. In some cases, pronounced movements in the stock market can accurately signal a fundamental change in the economy but in most cases, these movements prove to be little more than ‘noise’ created by fear, greed, or the interaction between conflicting investment strategies. 

You can generally divide investment strategy (or investment mentality) into four main camps: 1) buy and hold; 2) momentum; 3) value; and 4) pure speculation. Each of these investor types makes buying and selling decisions based on a different set of rules and impacts the market in different ways. The buy and hold investor is the most benign of the camps. They don’t make investment and asset allocation decisions based on current market conditions. This type of investor simply purchases stocks when they have capital available and looks to hold these positions for years or even decades through various market cycles and economic conditions. Momentum traders and value investors, on the other hand, do not invest passively; they actively look for opportunities that they believe can be profitably exploited. Momentum traders make investment decisions based on stock price and volume trends. Increasing stock prices and growing volumes signal the buy opportunity while declining share prices and volumes signal sells. Value investors take the approach of focusing on fundamentals (such as earnings, cash flow, growth and financial position). Value investors want to buy stocks when they are cheap relative to underlying earnings and cash flow and will often purchase companies that have recently experience a price decline or that are largely unknown, untraded or just currently unloved. Pure speculators are less relevant to this discussion but would exhibit buying and selling behaviour similar to that of the momentum camp.

The effect that momentum traders and value investors have on market volatility is polarized. When the market moves in one direction, the momentum traders exacerbate the movement and therefore increase market volatility, by increasing buying when the market is rising and increasing selling when the market is falling. In fact, momentum traders unwittingly work together to generate market extremes. But when market prices move too far in either direction, value investors get involved. When prices get too high, value investors create a dampening effect by selling into the strength as many of the stocks they own have likely become overvalued. The selling results in a slowing or reversal of the previous uptrend, which signals to momentum traders that it is time to sell. As the market weakness persists, more and more momentum trades drive prices continuously lower until stocks get to a point where they start to look undervalued. This signals to value investors that it is time to start buying again which stabilizes the downward trend and once again can even reverse. And so on and so forth, the cycle continues.

Obviously not all investors can neatly be categorized into one of these investment types. Real world investment strategy involves a lot of human behavior and is too complex to be summarized into a few lines of text. Some investors will utilize multiple investment strategies. For example, an investor can purchase on value but then transition to a buy and hold approach. Investors can also purchase on initial momentum but then sell on value. Some investors will subscribe to one strategy in theory but another in practice. Some investors switch between strategies from trade to trade. And in the case of professional money managers, there is also the structural issue of investor contributions and redemptions: the fund manager may subscribe to a value strategy, but if the fund investors decide to redeem in down markets and contribute in up markets, the impact the fund has on the market may be more closely associated with momentum than with value.

Complexities aside, most investors, whether they know it or not, are largely loyal to their respective strategy. Equally true is the growing trend in favour of momentum strategies. This trend, which naturally increases volatility, is being driven by a number of factors. The evolution of discount brokerages and low cost trading has made trading easier from a logistical and financial perspective. Many brokerages also encourage excessive trading by offering lower fees to high-frequency traders and platforms which provide momentum-based research tools. Next, a virtual explosion has occurred in the market in the usage of computerized trading programs that promise to automate the BUY/SELL decision for unsophisticated investors. Of course, legitimate global economic risks and the fresh memory of recent stock market crashes have also made investors more willing to hit the sell button at the first sign of trouble and potentially the buy button when the market appears to be improving. And finally we have the growing influence of high frequency trading (HRT) companies, which have exploded in numbers and importance over the past several years. HRT uses sophisticated computing programs to execute (in some cases) thousands of trades per minute, resulting in profits of a faction of a cent per trade. The impact of HRT in today’s market is becoming more and more evident. Estimates will vary, but the research we have seen is staggering. In August 2011 (an extremely volatile period), Bloomberg reported that the percentage of average daily volume attributable to high frequency trading had exceeded 80% in the U.S. markets.

We only need to look to the Flash Crash of 2010 (also referred to as The Crash of 2:45) for a not so distant example of how momentum trading creates abnormal volatility. The Flash Crash occurred on May 6, 2010, when the Dow Jones Industrial Average plunged about 1000 points and then quickly recovered after a few minutes. This was the biggest intraday point decline in the Dow’s history. On September 30th, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) issued a report on the crash after a five month investigation. The report “portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral.” The report also discussed how immediately before the crash, a large institutional investor sold an unusually large number of S&P 500 contracts. The report concluded that this activity put selling pressure on an already weak market, which triggered high-frequency traders to start selling aggressively, causing a mini-crash to occur.

When we examine how different investment strategies interact with each other it is easy to understand why markets have been so volatile over the last 4 years. There has always been a divide between momentum and value investors. The difference today, in addition to legitimate economic concerns, is that technology has facilitated a trend in favour of momentum trading and the decline in per trade brokerage commissions over the last 10 years may actually be driving firms to encourage higher frequency client trading. But although hyper-volatility is very frightening to most retail investors it actually presents a great opportunity. Ultimately, a stock is a piece of a business and as long as that business generates positive cash flow, it will be able to invest in growth, pay a dividend, and command a fair price in a takeover transaction. There is nothing disconcerting if momentum traders give value investors the opportunity to purchase these companies at discounted prices, and then potentially sell them right back when those prices become inflated.

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