NOTE: I wrote this a few months ago but wasnt sure if I wanted to publish it. I decided to today. Yes, I know Howard Marks is one of the great investors of all time. That just makes his meaningless banter even worse.

As someone who enjoys putting my thoughts to paper every now and then I always strive to say something meaningful. Sometimes it is only meaningful to me and not to anybody else, but I try to avoid the temptation of striving to tell the world how smart I am without actually saying anything smart.

And why should I? After all, I am not a hedge fund manager. Around 20 years or so ago when I did work for a hedge fund it became trendy to try to get the quarterly investment letters from hedge fund managers to find out what the real smart guys are actually thinking.

As the internet proliferated and such letters started to be delivered by email it became de rigeur for hedge fund managers to write confidential letters to clients that are clearly targeted to the public as a whole. A case in point is the following letter from Howard Marks of Oaktree. Lets address it line by line:

I want to provide a memo on this topic before I – and hopefully many of my readers – head out for yearend holidays. I’ll be writing not with regard to the right price for oil – about which I certainly have no unique insight

All good investment letters start out with the obligatory humble remark that the author is just another guy with no particular insights.

but rather, as indicated by the title, about what we can learn from recent experience.

Let me guess, sometimes asset prices move in ways that are not largely anticipated?

Despite my protestations that I don’t know any more than others about future macro events – and thus that my opinions on the macro are unlikely to help anyone achieve above average performance – people insist on asking me about the future

Ahh, nice, a second humble remark followed by just how smart everyone thinks he really is and so he will oblige us with his insights.

Over the last eighteen months (since Ben Bernanke’s initial mention that we were likely to see some “tapering” of bond buying), most of the macro questions I’ve gotten have been about whether the Fed would move to increase nterest rates, and particularly when.

You and literally 99.9% of the population loosely involved with finance and/or the stock market.

These are the questions that have been on everyone’s mind.

Yup

Since mid-2013, the near-unanimous consensus (with credit to DoubleLine’s Jeffrey Gundlach for vocally departing from it) has been that rates would rise.

And what was your opinion?

And, of course, the yield on the 10-year Treasury has fallen from roughly 3% at that time to 2.2% today. This year many investing institutions are underperforming the passive benchmarks and attributing part of the shortfall to thefact that their fixed income holdings have been too short in duration to allow them to benefit from the decline of interest rates.

Sometimes everyone is wrong. Who knew?

While this has nothing to do with oil, I mention it to provide a reminder that what “everyone knows” is usually unhelpful at best and wrong at worst.

Thanks.

Not only did the investing herd have the outlook for rates wrong, but it was uniformly inquiring about the wrong thing. In short, while everyone was asking whether the rate rise would begin in December 2014 or April 2015 (or might it be June?)

Yes we got it. The masses were wrong. Were you? What was your prediction?

in response to which I consistently asked why the answer matters and how it might alter investment decisions

So you are the kind of guy who answers questions with questions. Got it. I hate people who do that.

few people I know were talking about whether the price of oil was in for a significant change.

Huh? Ill bet when they were talking about what was going to happen to rates they also werent brining up what they had for dinner the night before also. Did you bring up what could happen to the price of oil when thinking about what would happen to rates? I doubt it.

Back in 2007, in It’s All Good,

Im not going to buy your book.

I provided a brief list of some possibilities for which I thought stock prices weren’t giving enough allowance.

Great, and how did that work out?

>I included “$100 oil” (since a barrel was selling in the $70s at the time)

So you thought what basically every single other person in the market thought.

and ended with “the things I haven’t thought of.”

In addition to the humbling statement in the beginning every single letter like this also has the I am so smart because I anticipate that which cant be anticipated.

I suggested that it’s usually that last category – the things that haven’t been considered – we should worry about most.

Give it a rest. Literally every single book or memo from a guru says this.

Asset prices are often set to allow for the risks people are aware of. It’s the ones they haven’t thought of that can knock the market for a loop.

No shit. Known things are already priced in. Unknown things arent. Thanks for the deep insight.

In my book The Most Important Thing,

Im not going to buy this book either

I mentioned something I call “the failure of imagination.” I defined it as “either being unable to conceive of the full range of possible outcomes or not understanding the consequences of the more extreme occurrences.” Both aspects of the definition apply here.

Yes yes, the standard everyone isnt smart and doesnt think of all the possibilities except you know, me, and every other guru out there who says the exact same thing.

The usual starting point for forecasting something is its current level.

Well of course, what do you propose instead? I cant wait for the deep insight.

Most forecasts extrapolate, perhaps making modest adjustments up or down. In other words, most forecasting is done incrementally, and few predictors contemplate order-of-magnitude changes. Thus I imagine that with Brent crude around $110 six months ago, the bulls were probably predicting $115 or $120 and the bears $105 or $100. Forecasters usually stick too closely to the current level, and on those rare occasions when they call for change, they often underestimate the potential magnitude.

OK, so how would you have analyzed the price of oil 6 months ago without including in that analysis of the information updated every second by participants in the market i.e. the price?

Very few people predicted oil would decline significantly, and fewer still mentioned the possibility that we would see $60 within six months.

I actually did, but I was early. Leaving that aside, what did you think? Christ we are multiple paragraphs into this now and we are still stuck on nobody predicts anything right. I may or may not have, I wont tell you that, but I do know that I think outside the box unlike everyone else!

For several decades, Byron Wien of Blackstone (and formerly of Morgan Stanley, where he authored widely read strategy pieces) has organized summer lunches in the Hamptons for “serious,” prominent investors. At the conclusion of the 2014 series in August, he reported as follows with regard to the consensus of the participants:

Yeah we got it. The serious investors are going to be just as wrong as everyone else.

Most believed that the price of oil would remain around present levels. Several trillion dollars have been invested in drilling over the last few years and yet production is flat because Nigeria, Iraq and Libya are producing less. The U.S. and Europe are reducing consumption, but that is being more than offset by increasing demand from the developing world, particularly China. Five years from now the price of Brent is likely to be closer to $120 because of emerging market demand.

Yup, I was right. Whats the insight here? Oh I got it, everyone is wrong all the time, except for him. Well, me might be wrong, we dont know, but I assure you that after the fact he is capable of pointing out that everyone else was wrong.

I don’t mean to pick on Byron or his luncheon guests.

Then why are you?

In fact, I think the sentiments he reported were highly representative of most investors’ thinking at the time.

Everyone was wrong about oil. We got it. Were you?

As a side note, it’s interesting to observe that growth in China already was widely understood to be slowing, but perhaps that recognition never made its way into the views on oil of those present at Byron’s lunches.

Ah, so, the smart people knew growth in China was slowing AND they used that in their analysis of what might happen to oil? Wow, lets track those people down unlike the serious investors and hedge fund managers as well as all of the buyers and sellers in the oil market who never considered that what happens in China might affect the price of oil.

This is an example of how hard it can be to appropriately factor all of the relevant considerations into complex real-world analysis.

Man, youre right. Taking the leap that what happens to the economy in China might affect oil is just too difficult for most people.

Turning to the second aspect of “the failure of imagination” and going beyond the inability of most people to imagine extreme outcomes, the current situation with oil also illustrates how difficult it is to understand the full range of potential ramifications.

OK great, finally some insight. Please tell us all these things that people who fail to imagine like you do dont understand.

Most people easily grasp the immediate impact of developments, but few understand the “second-order” consequences . . . as well as the third and fourth

OK cool, so you are going to tell us the 5th and 6th order affects that most people dont grasp. Awesome, finally some content.

When these latter factors come to be reflected in asset prices, this is often referred to as “contagion.”

What, you mean banks going under because they loaned money to people who couldnt pay it back is a 5th order consequence? I wonder what consequences 1-4 were.

Everyone knew in 2007 that the sub-prime crisis would affect mortgage-backed securities and homebuilders, but it took until 2008 for them to worry equally about banks and the rest of the economy.

Everyone was smart enough to know the affect on MBS and homebuilders but too stupid to see how it would affect banks? Oh come on. How about the market had no idea just how bad the situation was and just how much the banks were levered against it. Oh, by the way, were YOU smart enough to worry about the banks in 2007?

The following list is designed to illustrate the wide range of possible implications of an oil price decline, both direct consequences and their ramifications:

Great, finally, lets see those 5th and 6th order consequences that we are too stupid to see.

o Lower prices mean reduced revenue for oil-producing nations such as Saudi Arabia, Russia and Brunei, causing GDP to contract and budget deficits to rise.
o There’s a drop in the amounts sent abroad to purchase oil by oil-importing nations like the U.S., China, Japan and the United Kingdom.
o Earnings decline at oil exploration and production companies but rise for airlines whose fuel costs decline.
o Investment in oil drilling declines, causing the earnings of oil services companies to shrink, along with employment in the industry.
o Consumers have more money to spend on things other than energy, benefitting consumer goods companies and retailers.
o Cheaper gasoline causes driving to increase, bringing gains for the lodging and restaurant industries.

With the cost of driving lower, people buy bigger cars – perhaps sooner than they otherwise would have – benefitting the auto companies. They also keep buying gasoline powered cars, slowing the trend toward alternatives, to the benefit of the oil industry.

o Likewise, increased travel stimulates airlines to order more planes – a plus for the aerospace companies – but at the same time the incentives decline to replace older planes with fuel-efficient ones. (This is a good example of the analytical challenge: is the net
impact on airplane orders positive or negative?)
o By causing the demand for oil services to decline, reduced drilling leads the service
companies to bid lower for business. This improves the economics of drilling and thus
helps the oil companies.
o Ultimately, if things get bad enough for oil companies and oil service companies, banks
and other lenders can be affected by their holdings of bad loans.

You have got to be kidding me. The things that EVERYONE has been talking about every day are your insights?

Further, it’s hard for most people to understand the self-correcting aspects of economic events.

Cool, lets learn some things I dont know

o A decline in the price of gasoline induces people to drive more, increasing the demand for oil.
o A decline in the price of oil negatively impacts the economics of drilling, reducing additions to supply.
o A decline in the price of oil causes producers to cut production and leave oil in the ground to be sold later at higher prices.

Is this guy for real?

In all these ways, lower prices either increase the demand for oil or reduce the supply, causing the price of oil to rise (all else being equal). In other words, lower oil prices – in and of themselves – eventually make for higher oil prices. This illustrates the dynamic nature of economics.

Lets sum up the article to this point:

1. I have no special insight on things, I am just a humble guy pressured into sharing my thoughts with you.

2. The crowd is often wrong, including the pros.

3. But, I have special insight into how everyone else is short-sighted.

4. That being said I wont tell you what I thought at the time.

5. But look at these insights I have, which you might have heard 100 times already by anyone else you have spoken to.

Finally, in addition to the logical but often hard-to-anticipate second-order consequences or knock-on effects,

Wait a minute. Earlier you said 1st and 2nd order (even 3rd or 4th) were easy, but that the 5th and beyond were hard. Anyway, is there a single person alive who hasnt extrapolated the fact that when oil prices go down countries which sell oil will receive less money for it?

negative developments often morph in illogical ways.

ok, lets get some fresh insight.

Thus, in response to cascading oil prices, “I’m going to sell out of emerging markets that rely on oil exports” can turn into “I’m going to sell out of all emerging markets,” even oil importers that are aided by cheaper oil.

Assuming anyone has made that argument, if mutual funds hold assets in a wide range of emerging markets than the decision to sell out of emerging markets that rely on oil exports will certainly impact the short term price of all emerging markets as people liquidate their emerging markets ETFs and funds.

In part the emotional reaction to negative developments is the product of surprise and disillusionment. Part of this may stem from investors’ inability to understand the “fault lines” that run through their portfolios. Investors knew changes in oil prices would affect oil companies, oil services companies, airlines and autos. But they may not have anticipated the effects on currencies, emerging markets and below-investment grade credit broadly.

I somehow doubt that considering the past correlations, but again I wonder if he saw all of this coming.

Among other things, they rarely understand that capital withdrawals and the resulting need for liquidity can lead to urgent selling of assets that are completely unrelated to oil.

Perhaps this is true for anyone who entered the market in 2009 and has never bothered to study pre 2009 market history.

People often fail to perceive that these fault lines exist, and that contagion can reach as far as it does. And then when that happens, investors turn out to be unprepared, both intellectually and emotionally.

Perhaps.

A grain of truth underlies most big up and down moves in asset prices

That, and the billions of dollars exchanged in open markets that determine the price.

Not just “oil’s in oversupply” today, but also “the Internet will change the world” and “mortgage debt has historically been safe.” Psychology and herd behavior make prices move too far in response to those underlying grains of truth, causing bubbles and crashes, but also leading to opportunities to make great sales of overpriced assets on the rise and bargain purchases in the subsequent fall.

Sometimes markets get out of control and the wise man sells at the top. Did you?

If you think markets are logical and investors are objective and unemotional, you’re in for a lot of surprises. In tough times, investors often fail to apply discipline and discernment;

People are too bullish at the top and too bearish at the bottom. Got it.

psychology takes over from fundamentals; and “all correlations go to one,” as things that should
be distinguished from each other aren’t.

People panic and run for the exits. OK, got it. However isnt the S&P making new highs?

To give you an idea about how events in one part of the economy can have repercussions in other economic and market segments, I’ll quote from some of the analyses I’ve received this week from Oaktree investment professionals:

Ah, ok. Perhaps you are just a professional blow-hard that relies on your analysts. Great, lets hear some insight:

Energy is a very significant part of the high yield bond market. In fact, it is the largest sector today (having taken over from media/telecom, which has traditionally been the largest). This is the case because the exploration industry is highly capital-intensive, and the high yield bond market has been the easiest place to raise capital.

You have an analyst who knows that the energy industry issues lots of high-yield bonds. Good job with that hire. Youd better give him a raise before a competitor steals him from you.

The knock-on effects of a precipitous fall in bond prices in the biggest sector in the high yield bond market are potentially substantial: outflows of capital, and mutual fund and ETF selling.

Interesting you understand that here, but find it strange when the same thing happens in emerging markets.

>It would be great for opportunistic buyers if the selling gets to sectors that are fundamentally in fine shape . . . because a number of them are. A wise man buys under-priced assets when everyone is panic selling.

Yes. What opportunities do you see?

And, in fact, low oil prices can even make them better.

Like what? Give us some ideas.

An imperfect analogy might be instructive: capital market conditions for energy-related assets today are not unlike what we saw in the telecom sector in 2002. As in telecom, you’ve had the confluence of really cheap financing, innovative technology, and prices for the product that were quite stable for a good while. [To this list of contributing factors, I would add the not-uncommon myth of perpetually escalating demand for a product.

Interesting. Thank you. Finally.

These conditions resulted in the creation of an oversupply of capacity in oil, leading to a downdraft. It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general “contagion.”

I must have missed the great financial contagion of 2002.

Selling has been reasonably indiscriminate and panicky (much like telecom in 2002) as managers have realized (too late) how overexposed they are to the energy sector. Trading desks do not have sufficient capital to make markets, and thus price swings have been

OK

predictably volatile.

Which you made money off I presume?

The oil selloff has also caused deterioration in emerging market fundamentals and may force spreads to gap out there. This ultimately may create a feedback loop that results in contagion to high yield bonds generally.

So your great insight is that the price of oil will affect emerging markets and the high yield market? Awesome. What do you get, 2 and 20%?

Over the last year or so, while continuing to feel that U.S. economic growth will be slow and unsteady in the next year or two,

OK, finally a prediction

I came to the conclusion that any surprises were most likely to be to the upside. And my best candidate for a favorable development has been the possibility that the U.S. would sharply increase its production of oil and gas. This would make the U.S. oil independent, making it a net exporter of oil and giving it a cost advantage in energy – based on cheap production from fracking and shale – and thus a cost advantage in manufacturing. Now, the availability of cheap oil all around the world threatens those advantages. So much for macro forecasting!

So you thought that a massive increase in the supply of oil and gas would result in a price increase? Didnt you also know that growth was slowing in China?

There’s a great deal to be said about the price change itself. A well-known quote from economist Rudiger Dornbusch goes as follows: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.”

Ok whatever.

I don’t know if many people were thinking about whether the price of oil would change,

Well, Byron Weins friends were, as you previously related.

but the decline of 40%- plus must have happened much faster than anyone thought possible.

To be honest, I thought it was, but then again I dont have a clear record to boast of.

“Everyone knows” (now!) that the demand for oil turned soft (due to sluggish economic growth, increased fuel efficiency and the emergence of alternatives) at the same time that the supply was increasing (as new sources came on stream).

Who didnt know that before? Did you have analysts that told you otherwise?

Equally, everyone knows that lower demand and higher supply simply lower prices.

No shit.

Yet it seems few people recognized the ability of these changes to alter the price of oil.

Perhaps

A good part of this probably resulted from belief in the ability of OPEC (meaning largely the Saudis) to support prices by limiting production.

Perhaps. I think it was more that people thought political instability would keep prices high.

A price that’s kept aloft by the operation of a cartel is, by definition, higher than it would be based on supply and demand alone

gee, thanks

Maybe the thing that matters is how far the cartelized price is from the free-market price; the bigger the gap, the shorter the period for which the cartel will be able to maintain control. Initially a cartel or a few of its members may be willing to bear pain to support the price by limiting production even while others produce full-out. But there may come a time when the pain becomes unacceptable and the price supporters quit. The key lesson here may be that cartels and other anti-market mechanisms can’t hold forever.

Yes, this is Econ 101. Thanks

As Herb Stein said, “If something cannot go on forever, it will stop.” Maybe we’ve just proved that this extends to the effectiveness of cartels.

Or maybe the Saudis want to kill the price to hurt the US oil industry, Iran, and Russia.

Anyway, on the base of 93 million barrels a day of world oil use, some softness in consumption combined with an increase in production to cut the price by more than 40% in just a few months.

thanks for the info.

What this proves – about most things – is that to Dornbusch’s quote above we should append the words “. . . and they go much further than you thought they could.”

I would think that a 5th order thinker like yourself could have imagined this.

The extent of the price decline seems much greater than the changes in supply and demand would call for.

You skipped day two of econ 101. Something about pricing at the margin.

Perhaps to understand it you have to factor in (a) Saudi Arabia’s ceasing to balance supply and demand in the oil market by cutting production, after having done so for many years, and (b) a large contribution to the decline on the part of psychology.

Is this your 5th order thinking on display?

(In the “conspiracy theory” department, consider the rumor that Saudi Arabia is allowing or abetting the price drop in order to either punish Iran, Iraq and ISIL; put the U.S. shale oil industry out of business; or discipline the more profligate members of OPEC . . . take your pick.)

It may or may not be true, but it is not a conspiracy to say that the Saudis can affect the price of oil and have been perfectly fine with the decline in prices.

The price of oil thus may have gone from too high (supported by OPEC and by Saudi Arabia in particular) to too low (depressed by negative psychology).

So you are long here?

It seems to me with regard to the latter that the price fell too far for some market participants to maintain their equanimity. I often imagine participants’ internal dialogues. At $110, I picture them saying, “I’ll buy like mad if it ever gets to $100.” Because of the way investor psychology works, at $90 they may say, “If it falls to $70, I’ll give serious thought to buying.” But at $60 the tendency is to say, “It’s a falling knife and there’s no way to know where it’ll stop; I wouldn’t touch it at any price.”

So you are long here?

It feels much better to buy assets while they’re rising. But it’s usually smarter to buy after they’ve fallen for a while. Bottom line, as noted above: there’s little logic in investor psychology

Yeah, we got it.

I said it about gold in All That Glitters (November 2010)

Im not going to buy it, but lets see what you said:

and it’s equally relevant to oil:

This should be good.

it’s hard to analytically put a price on an asset that doesn’t produce income.

Well, you know, you can always see what it is trading for in the open market.

In principle, a nonperishable commodity won’t be priced below the variable production cost of the highest-cost producer whose output is needed to satisfy total demand.

Perhaps the highest cost producer is over-estimating future demand.

But in reality and in the short run, strange things can happen. It’s clear that today’s oil price is well below that standard. It’s hard to say what the right price is for a commodity like oil . . . and thus when the price is too high or too low. Was it too high at $100-plus, an unsustainable blip? History says no:

Well, it did go down 40%

It was there for 43 consecutive months through this past August. And if it wasn’t too high then, isn’t it laughably low today?

Perhaps the oil market 43 months ago is different than today?

The answer is that you just can’t say. Ditto for whether the response of the price of oil to the changes in fundamentals has been appropriate, excessive or insufficient. And if you can’t be confident about what the right price is, then you can’t be definite about financial decisions regarding oil.

So lets sum up the article to this point:

I have no insights whatsoever beyond what everyone else has, but I decided to write this letter because I am so smart and can see 5th order things (despite the fact that I opened this letter pretending that I dont think Im so smart).

In the last few years, as I said in The Role of Confidence (August 2013),

Im not going to buy it

investor sentiment has been riding high.

who knew?

Or, as Doug Kass pointed out this past summer, there’s been “a bull market in complacency.”

I gotta admit, that is wittier than anything you have said so far.

Regardless, it seems that a market that was unconcerned about things like oil and its impact on economies and assets now has lost its composure. Especially given the pervasive role of energy in economic life, uncertainty about oil introduces uncertainty into many aspects of investing.

Yet the S&P is at or near all time highs.

“Value investing” – the form of investing Oaktree practices – is supposed to be about buying based on the present value of assets, rather than conjecture about profit growth in the far-off future.

How can you value an asset without making assumptions about future income streams>

But you can’t assess present value without taking some position on what the future holds, even if it’s only assuming a continuation of present conditions or perhaps – for the sake of conservatism – a considerably lower level.

OK, and?

Recent events cast doubt on the ability to safely take any position.

So you have no idea what to do and cant value anything? And you get paid 2 and 20%?

One of the things that’s central to risk-conscious value investing is ascertaining the presence of a generous cushion in terms of “margin of safety.” This margin comes from conviction that conditions will be stable, financial performance is predictable, and/or an entry price is low relative to the asset’s intrinsic value.

If you cant predict anything, you need to pay a lower price to make sure your margin of safety still exists.

But when something as central as oil is totally up for grabs, as investors seem to think is the case today, it’s hard to know whether you have an adequate margin.

Do you think its up for grabs? can you value it? What do you think?

Referring to investing, Charlie Munger told me, “It’s not supposed to be easy.” The recent events surrounding oil certainly prove that it isn’t.

Thats some great insight right there.

On the other hand – and in investing there’s always another hand – high levels of confidence, complacency and composure on the part of investors have in good measure given way to disarray and doubt, making many markets much more to our liking.

So you are long? what are you long? what are you buying?

For the last few years, interest rates on the safest securities – brought low by central banks – have been coercing investors to move out the risk curve. Sometimes they’ve made that journey without cognizance of the risks they were taking, and without thoroughly understanding the investments they undertook. Now they find themselves questioning many of their actions, and it feels like risk tolerance is being replaced by risk aversion. This paragraph describes a process through which investors are made to feel pain, but also one that makes markets much safer and potentially more bargain-laden.

As the S&P 500 makes new highs?

In particular with regard to the distress cycle, confident and optimistic credit markets permit the unwise extension of credit to borrowers who are undeserving but allowed to become overlevered nevertheless.

We know.

Negative subsequent developments can render providers of capital less confident, making the capital market less accommodative. This cycle of easy issuance followed by defrocking has been behind the three debt crises that delivered the best buying opportunities in our 26 years in distressed debt.

OK great, so you see an opportunity to buy assets on the cheap. Is that what you are doing? What do you like here?

We think it also holds the key to the creation of superior opportunities in the future. We’ve argued for a few years that credit standards were dropping as investors – chasing yield – became less disciplined and less discerning. But we knew great buying opportunities wouldn’t arrive until a negative “igniter” caused the tide to go out, exposing the debt’s weaknesses. The current oil crisis is an example of something with the potential to grow into that role. We’ll see how far it goes.

So you are not long here yet. ok.

For the last 3½ years, Oaktree’s mantra has been “move forward, but with caution.”

You forgot to add and say nothing useful, while telling you all how smart we are.

For the first time in that span, with the arrival of some disarray and heightened risk aversion, events tell us it’s appropriate to drop some of our caution and substitute a degree of aggressiveness.

Wait, so you are long here?