One of the reasons why people make mistakes when they are investing is that they tend to mistake short term trends for long term ones. In other words, they take a pattern over a few days, months, or even a year, and they project that pattern out over a number of years and draw conclusions from that projection. This can often lead to extreme and misleading conclusions which can cause a lot of problems for an investor.
Here's a Good Example
From 2004 through to 2008, the price of oil was rising as supply was constrained and demand was growing steadily. At the time, some people wondered if the price of oil would ever drop below $100 a barrel again and people openly predicted prices of $200 a barrel and ensuing economic ruin from higher transportation costs. Of course these predictions look silly today as we are one month removed from $-40.00 a barrel oil. But these were seriously considered opinions at one point, and some of them even came from experts.
The mistake made of course was that they took the short term trends of supply and demand and projected them far into the future. This of course led to very inaccurate results. As prices went up, oil producers went in search of more oil to drill. Technological advances gave birth to the shale oil revolution and eventually supply rose to meet the increased demand. Today we have predictions of the demise of oil and questions of whether oil will ever be priced ABOVE $100 a barrel again.
I won't go so far as to make a prediction that it will, but what I do know is that anybody who is predicting that oil will not be priced at $100 a barrel ever again, probably doesn't have any more certainty than you or I do about predicting oil prices in the future. It is simply very hard to predict where the price of oil will go in the future. One of my recent blog posts was on making predictions, and the pitfalls of trying to predict anything too specifically. Another pitfall is the cognitive bias that we all have that makes it hard for us to see beyond our current circumstances.
In the midst of the pandemic, a Saudi-Russia oil price war, and constant calls for reducing fossil fuel use in order to combat climate change, it was difficult in April to see how oil could ever be profitable again in Canada. Of course only 2 months later and oil prices are pretty close to levels where they are profitable again for many companies. Anyone who predicted the end of oil was only looking at the short term trends, and failed to see the long term picture.
Speaking of climate change, it provides an excellent metaphor for explaining the difference between a cyclical change and a secular change. A cyclical change is a short term pattern that moves in a somewhat regular pattern. With weather, the pattern is very easy to predict. It's called the seasons, and they happen pretty much at the same time every year. If you were to take the drop in temperatures from September to December in Winnipeg, and projected that out into the future, you would quickly be signing up for Elon Musk's colonization program and trying to get off the Earth as soon as possible. Of course no one does this with weather, as the seasons are very regular and easy to predict. Weather is cyclical, and the changes in weather are cyclical changes which go up and down.
A secular change on the other hand is different. It means something has happened which has forever changed the previous pattern. If weather is cyclical, then climate change is a secular change. I won't get into whether or not climate change is a real threat or what we should do about it. You can do your own research on the internet. What's important though is to draw the clear differentiation between a cyclical change and a secular change, and then apply that to our investing.
While many people were calling for the permanent demise of oil, a wise investor would instead look at the situation and try to differentiate between what are cyclical changes in the price of oil, and what are secular changes. It is true that environmental impacts of oil and other fossil fuels are a legitimate reason to reduce their use. The world would indeed be a better place if we could replace fossil fuels with a clean and renewable source of energy. This is a trend which is secular. We will eventually replace fossil fuel use with more environmentally friendly and more renewable technologies. This is inevitable and is happening steadily.
HOWEVER, the current rapid drop in demand for oil is related to the COVID 19 Pandemic, and the related shut downs. This drop in demand is more cyclical than anything else and will bounce back when the pandemic recedes and lockdowns are ended. This might take months or even a year, but eventually the consumption of oil will resume at higher levels.
The mistake that many people made was to treat this short term cyclical drop as a sign of a deeper secular change. But the idea that we were going to permanently lose 20-25% of fossil fuel consumption overnight is a bit far fetched. Fossil fuels are still integral to things like agriculture, air and sea transportation, steel production and other manufacturing, chemical production, and power generation. These will eventually evolve as I said, but there is no realistic scenario where fossil fuels are replaced in a matter of months. As a result of this mistake by investors though, oil companies dropped to extremely low prices in March which created an opportunity for long term investors. There are other changes which may turn out to be secular changes, or they may prove to be only cyclical.
The early signs are that this could be the start of a long term secular trend which could impact commercial real estate, hiring and employment practices, transportation, and all kinds of other industries. On the other hand, we may find that working from home doesn't prove to be as useful as working in a collaborative environment in an office, and the recent surge in working from home could end up being more cyclical. That's something I wouldn't want to predict.
One trend that I think will endure is the surge in E-Commerce. This surge is actually re-inforcing a pre-existing secular trend towards e-commerce and away from brick and mortar, and as such I think that trend will likely continue even after the pandemic. Businesses that benefited from this in the past are very likely to continue to grow in the future.
Will this ordeal create a long term resistance or fear of travelling around the world. Only time will tell on a lot of these current trends. Investors in these businesses need to be extra careful.
Being able to identify whether a change is secular or cyclical is absolutely critical, because it will have a drastic impact on the future results for businesses you invest in. If you can't figure it out yet, you might want to stay away from that investment altogether.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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