The Most Important Lesson You Can Learn from the Carnage in Oil

Oil production and the pipe
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A prolonged international music career is one of the most difficult things to achieve. It’s an industry that won’t put up with fakes or frauds, not for long, anyway. That David Bowie managed to survive and thrive over four decades is a testament to his genius.

The key to his success was his ability to change…to reinvent himself while still remaining real. It turned out that others didn’t see the faker.

In an increasingly fake world, one of easy money and Kardashian-watching, Bowie, even in old age, showed how it should be done. The world just lost a legend. Rest in peace, David Bowie.

Changes are taking place in the oil market too. The vicious bear market is gathering speed.

At a time when volatility is gut-wrenchingly high, the performance of oil is a standout. There is outright panic in the market. From the Financial Review:

A brutal new year selloff in oil markets quickened, with prices plunging 6 per cent to new 12-year lows as further ructions in the Chinese stock market threatened to knock crude as low as $US20 a barrel.

Amid an accelerating tailspin that shows no sign of slowing, Monday’s dive – the biggest one-day loss since September – triggered a rash of panicky trading across the market.

What’s behind the panic? No one really knows, and that is the point.

It’s not simply a story of excess supply and waning demand. The market knows about that. There is something else going on. It has to do with what’s happening in China. It’s also related to speculative positioning in the futures market.

According to Saxo Bank, the ‘net long’ position of hedge funds in oil futures is at a five-a-half-year low. Hedge funds are like piranhas…or lemmings. When momentum builds in a market, they jump on board and try to make some easy gains.

Contrary to the general perception, most hedge funds are not that savvy. Years of easy money provided the industry with way more capital than it had the brains to manage. Bereft of ideas, most hedge funds are simply momentum traders.

So when something looks like an easy target, they all jump on board. In my view, that’s why you’re seeing such extreme moves to the downside. That’s not to say this move isn’t about the fundamentals. The supply and demand outlook isn’t pretty. But I’d bet that hedge funds are behind the recent extreme moves.

There’s a really important lesson you can learn here. During high levels of turmoil like this, most investors often lose focus. Bears revel in the carnage while bulls take on a ‘deer in headlights’ stance.

But there IS a lesson in this.

It’s a simple one too. It’s this…

Don’t have an opinion! Put your ego to one side and let the market guide your thinking. If you do this, investing will become much easier, I promise you.

What I mean by that is: don’t try and guess where the bottom is. Since oil’s initial big decline last year, investors have lost billions trying to pick the bottom. In December, Bloomberg had the following headline, ‘ETF Investors Have Spent $24 Billion Trying to Call a Bottom in Oil’

The price, as you know, has since endured another big leg down. That means more losses. Who wants to call the bottom now?

The bottom callers make the fatal mistake of thinking they know best. ‘Surely the price can’t fall much further’, they say. Instead of thinking about the downside risk, they only see the potential upside.

It took me awhile to learn this, but fighting the dominant trend is a foolish exercise. You may get it right occasionally, but do it long enough and you will get it wrong more than enough to make up for your successes.

The smarter way to play it is to run with the trend. I’ll give you an example of how I did this in my subscription newsletter, Crisis & Opportunity. I relate it because, for many, the opportunity wasn’t that clear-cut.

In late 2014 I wrote about the dangers facing Australia’s fledgling LNG industry. I identified a number of large producers that were at risk, including Santos [ASX:STO]. I said there were good shorting opportunities emerging.

At the time the oil price had just suffered its first leg down. I expected a short term relief bounce, but instead the price continued to plunge. The stocks I identified earlier all fell sharply, BEFORE I recommended the trade.

The opportunity to ‘go short’ these stocks (and benefit from a share price decline) had momentarily gone. This time, oil really was due for a bounce. And bounce it did. It went from US$45 a barrel at the start of 2015 to US$60 by mid-year. Those who bought at the low thought they were smart indeed.

But the trend in the oil price remained down. I continued to monitor the stocks, waiting for an opportunity to go short. That opportunity came in August 2015. The trades are now strongly in profit.

The point of the story is to illustrate that you make money betting with the trend, not against it. I made the recommendations AFTER the oil price had already fallen considerably. Many investors did the opposite, thinking the oil price couldn’t go much lower.

Here’s a tip: Don’t think! Go with what the market is saying. It’s much smarter than you or I.

My guess now is that the oil price is close to its lows. I wouldn’t be making fresh bets on further falls. But I wouldn’t bet on a rebound either. I’ll wait for the market to tell me when the bottom is in. Playing it this way means you won’t ever pick the bottom. But that’s a good thing. Trying to do so consistently is impossible.

Keep this in mind when looking at other resource stocks to buy. If you thought BHP was cheap at $25 (and plenty of people did) then what makes you think it’s cheap at $15?

When the market is displaying such vicious volatility, you have to respect it and know the limitations of your own knowledge. So stand aside and watch the show.

With the tide receding so drastically though, you’d have to think that pretty soon you’ll start to see just how many investors (or big hedge funds) have been caught swimming naked?

More on that later in the week…

Greg Canavan,

For The Daily Reckoning

PS: As the saying goes, there are many ways to skin a cat. And there are many different ways to make money in the market. Small-cap specialist Sam Volkering has come up with a way to find ‘shockproof’ stocks, those that are immune from the type of volatility you’re seeing across markets now. To view Sam’s presentation, go here.

Join The Daily Reckoning on Google+

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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