Oil Prices, Energy Stocks, Signs and Portents by Salient Partners
Young nanny: Look at me, Damien! It’s all for you.
[she jumps off a roof, hanging herself]
– “The Omen” (1976)
When one has little faith, one must survive from day to day signs.
– Stephen King, “Bag of Bones” (1998)
Criminals are a superstitious cowardly lot, so my disguise must be able to strike terror into their hearts. I must be a creature of the night, black, terrible … a … a …
– Bob Kane and Bill Finger, “Batman” (1939)
When great leaves fall, the winter is at hand;When the sun sets, who doth not look for night?
? William Shakespeare, “Richard II” (1595)
Alas, why gnaw you so your nether lip?
Some bloody passion shakes your very frame:
These are portents; but yet I hope, I hope,
They do not point at me.
? William Shakespeare, “Othello” (1603)
Destiny does not send us heralds. She is too wise or too cruel for that.
? Oscar Wilde (1854 – 1900)
Like the criminals that Bruce Wayne fought as Batman, we investors are a superstitious, cowardly lot. We are constantly ascribing way too much import to this sign or that sign, constantly freaking out over the meaning and significance of this market event or that market event. It doesn’t help that the financial media world has devolved into fiefdoms of rah-rah soothsayers on the one hand and doom-seeing end-timers on the other, so that whatever our predispositions might be we can easily find Voices of Authority to read the entrails to our liking. And it really doesn’t help that we are in the midst of the greatest crisis of faith in the markets since the 1930’s, so that – as Stephen King wrote – we survive by looking for day-to-day signs to show us what to do.
And yet sometimes a little freaking out over the signs and portents is clearly the right thing to do. Sure, if your nanny declares her loyalty to your adopted-under-mysterious-circumstances devil-child as she hangs herself outside the nursery window it’s probably a case of mental illness, but I’d also listen a little more closely to what that pesky priest says. If you’re Pierce Brosnan in the “Bag of Bones” mini-series and you think that your dead wife is sending you cryptic messages via a handful of refrigerator magnets … well, maybe you should drive into town and buy more refrigerator magnets, see if she’s got anything interesting to say. If you’re Desdemona and you’re worried that Othello’s lip-biting is a sign that he’s about to fall into a jealous, murderous rage … well, maybe you should run out of the room instead of hanging around to see if you’re right.
It’s a tough call, evaluating what’s a “true” sign and what’s a “false” sign. Are we being foolish to sell our energy stocks after oil prices took another big hit, or are we reading the market’s tea leaves correctly and saving ourselves a lot of future pain? Are we acting as Shakespeare says any wise person would in a knowable and deterministic world, by putting on our cloaks as clouds appear and looking for the night as the sun sets? Or are we mistaking our play-acting market world for the real world, putting on our cloaks as the projectionist shows us a picture of clouds and looking for the night as the stage lights dim?
Here’s the Epsilon Theory answer: the latter mistake is 1,000 times more common than the former wisdom, and the vast majority of investors would be better off if they never read the newspaper and never turned on the TV. Why? Because what they think is a “sign” is actually a signal, neither true nor false in and of itself but only more or less influential in changing their mind and other investors’ minds about the world. (for more on signals and Information Theory, see “Through the Looking Glass” and “The Music of the Spheres”) Signals are constructed. Signals are malleable. And unless you are focused on how and why signals are constructed and shaped, you will be whipsawed. You will be shaken out. You will be roped in. You will catch a falling knife. Pick your own analogy or metaphor … there are a million to choose from and anyone who has spent any time at all in the market has experienced most of them. We’ve all been there.
Case in point: why are many investors puking energy sector stocks today? It’s not because they have a detailed cash flow model of the specific companies they’re selling and have calculated the incremental earnings impact of oil prices moving from a $70 handle to a $60 handle. It’s also not because there’s some credit freeze roiling financial markets and a careful balance sheet analysis shows imminent dividend cuts or debt stress throughout the sector. Will lower oil prices over a long period of time hurt earnings and crimp growth for the entire sector? Well, sure. That’s kinda what it means to invest in a cyclical stock, and if this comes as a surprise to you then I really don’t know what to say. Will lower oil prices over a long period of time create balance sheet distress in the energy sector’s more levered, go-go stocks? Absolutely. If you’re not stress testing the balance sheet, capital allocation, and distribution coverage models of the energy stocks you own, then you’re not doing your job as a risk manager. But neither earnings risk nor balance sheet risk explains why you see a spasm of energy sector selling today or back in October.
No, the selling is because the dominant Common Knowledge regarding energy sector stocks is that they move up and down with the price of oil. Common Knowledge is not what everyone knows; that’s the consensus. Common Knowledge is what everyone knows that everyone knows, and it’s the driving force behind the Game of Sentiment. Everyone knows that everyone knows energy stocks are tied to oil prices, we just took another sharp leg down in oil prices, and so energy stocks must be sold. The fact that energy stocks are down “proves” the relationship (a wonderful example of Soros’s concept of reflexivity), which adds to the selling. And “Even After Selloff, Energy Stocks Attract Few Buyers” because, as the WSJ breathlessly announces, “prices could soon plumb new depths.” Or not, but … hey, all the better to set-up that “rebound that no one was expecting” story. Until that story is written, any oil price increases are merely because “traders who had bet on lower prices locked in gains.” I find it awfully telling that this WSJ article now titled “U.S. Oil Prices Trade Higher After Selloff” was originally titled and archived as “Oil Slides as Market Struggles To Get Grip” (you can track URL’s to identify this stuff), but then the market failed to cooperate and they had to change the title!
A couple of Epsilon Theory points on all this.
The reality (not that it matters)