“We can know more than we can tell.” -Michael Polanyi
The New Year's underway, and despite finishing off the final quarter of 2014 with a modest bang, the initial days of 2015 have given way to new and renewed uncertainties. There have been several contributors to this, most notably the punishing decline in oil prices, as well as uncertainties in Europe, with Greece back in the headlines and the European Central Bank potentially exploring new stimulus measures.
While it's the traditional time of year for an "outlook", it isn't our intent here to provide yet another forecast, musing over whether GDP grows by 2.5% or 3%, or whether the stock market will be up or down this year. However, we are going to spend a bit of time talking about forecasts, and things important to consider when developing an outlook.
Over the holidays, I read the latest memo from well-known value investor Howard Marks. In it, he deftly made light of not only the poor forecasting record of experts, but the fact that much of the time they were forecasting the wrong thing - interest rates and when they'd move higher, rather than the prospect of oil prices plummeting -50%.
The point that he made was twofold: focusing on what everyone knows is usually unhelpful at best and wrong at worst; and that it's usually the things that experts aren't telling us that we should be thinking about. As a former forecaster, this made a ton of sense.
Ironically, forecasters tend to suffer greatest from the fear of being wrong. I can't think of a single person, for example, that said during the dot.com heyday, "sell all your tech stocks and buy bonds." With hindsight this would have been smart, but at the time they would have been made a laughing stock. Similarly, we don't know of anyone that recently said oil prices would plunge -50% in six months. Now that they have, we're seeing lots of $20 per barrel oil forecasts. What's too often given top priority in forecasting is the opinion of others, while "risk" is more concerned with going against what the consensus currently is. This is unfortunate, because it's the unexpected that causes confusion and uncertainty, as well as uncertainty's inverse, opportunity.
A natural takeaway, is why do forecasts matter? What should we do with them? After all, unless somebody has a monopoly on predictability, it is pretty difficult to be "right" versus everyone else concerned with the same thing.
It's relatively easy to grasp the immediate impact of today's developments, but much harder to properly assess their longer-term consequences. The rapid decline in oil prices will absolutely hurt many companies today, probably even taking some companies out of business altogether, ranging from marginal oil companies to the banks that financed them. Some entire countries too, those whose governments rely heavily on oil exports for budget "revenue" will likely face tough times ahead.
However, there will also be beneficiaries of lower energy prices. For still others it just won't matter much, as their futures may be inextricably tied to other forces, such as the advent and adoption of new technologies, the Internet in general, or the inevitable aging of the population. Moreover, oil's sharp decline in price also sets in motion it's own recovery. For example:
- A decline in the price of gasoline increases demand for oil, as more people are driving more often.
- A decline in the price of oil reduces supply, as new drilling becomes less profitable.
- Increased driving pressures airlines to lower fares, stimulating air travel, which in turn results in higher demand for fuel, and consequently, oil.
In these and many other similar ways, lower prices either increases oil demand or reduces supply which, everything else equal, promotes an eventual rise in oil prices.
As we look ahead, we see ample investment opportunities based upon longer-term hard fundamentals. A key reason is our perspective, which is to first determine how we arrived at where we are. From this perspective, we have a hard time dismissing that the economy has done reasonably well, despite the burden of high energy prices of the past six years. Now that national gasoline prices have returned to the same level as in 2008, we're slightly more optimistic than we otherwise would have been for many sectors of the economy.
Among the issues that do concern us, are those that have the potential to get in the way of a well-functioning economy. At the end of the day, we're all reliant upon what the economy does so well, allocating resources and capital to their best uses, so it's smooth operation is of particular importance. Accordingly, we tend to look at issues such as regulation: of the Internet (net neutrality, privacy), the banking sector (Graham-Dodd), healthcare (drug reimbursements) and international disputes (intellectual property, immigration), as a few examples of the bigger risks on the horizon. Each has the potential to not only throw sand into the inner-workings of the economy, but also determine large numbers of "winners" and "losers" across entire industries.
In reality, identifying great companies isn't that difficult; forecasting specific risks to their business is. Great companies tend to share common traits, what we refer to as the 3Ps: great people, amazing products and huge potential. It's a fourth "P" that's more elusive, predictability. This is what we need to be really disciplined about, as it's ultimately what gets us to the "right" price - or at least a price in the right neighborhood of reasonable.
As investors, entrusting our savings to the future, it's not forecasts but discipline that matters. Psychology and the all too frequent herd behavior in markets cause prices to move too far in response to current events, leading to bouts of volatility, even bubbles and busts, but also opportunities. The key to distinguishing one from the other is the consistent application of discipline, recognizing that one thing, doesn't impact all things equally. This isn't something mass investor psychology is terribly good at.
"Cautious optimism" has ruled our perspective for several years now, but with investor concern elevated, owing in part to declining oil prices and slow growth outside the U.S. - yet being priced into all markets - this is the sort of backdrop that suggests caution should give way to optimism.