Black Swans and Wildfires

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In a recent post, I wrote that oil prices are subject to much more risk on the upside than many people think. Sure enough, plenty of readers responded with reasons why I was wrong, insisting that prices couldn’t rise higher.

They might be right, of course, but recent events suggest the risk on oil prices remains much more to the upside than many believe.

Consider the recent fires in Canada. This is certainly a human tragedy, but it also seems to have pushed up oil prices as Canadian oil sands areas are shut down, reducing production. Who would have thought of fires in Canada as a risk for oil prices? Not me, and I don’t remember seeing anyone else call it out either—before it actually happened, that is.

When sentiment doesn’t keep pace with reality

In the past 10 years, we've seen gross mismatches between investor sentiment about oil prices and evolving risks. Several years ago, when Goldman Sachs came out with a report calling for oil to trade for $200 per barrel, the path ahead was clear: dropping supply, rising demand, and no end in sight for either trend. The actual outcome, of course, was different, and sentiment was slow to adjust. All the way down to $25 per barrel, analysts were arguing that prices couldn’t get any lower.

Now we see the reverse. With prices rising, many analysts are arguing that they won't go very high. Again, they have good reasons, but we need to be wary of making decisions based on what everyone knows and understands. They have been seriously wrong about oil in the recent past, and they might well be wrong again.

That was the gist of my earlier post, and the comments arguing for the status quo simply illustrate the point. They might be right, of course, but that is far from certain. In many ways, this is the central problem of investing—trying to identify things that everyone knows but are no longer true.

Keeping an eye on our blind spots

What bubbles are we seeing now? Here are a few prime candidates:

  • Interest rates. Everyone knows that rates can’t rise, so that will be true until it isn’t.
  • China. Everyone knows the Chinese government can manage its economy, its recent troubles notwithstanding.
  • U.S. stocks. Everyone feels good about rising stock prices, but valuations and debt levels are very high.

On a larger scale, there are signs that many of the consensus policies of the past several decades have also been in a bubble. Everyone knows free trade is good—but here come Donald Trump and Bernie Sanders. Everyone knows the European Union is a good thing—but here's the Brexit debate. Everyone knows immigration is good—but look again, both here and abroad.

Taking what everyone knows and reversing it isn’t a bad way to understand the current political season, both in the U.S. and other countries. Volatility—in politics, economics, and markets—occurs when the consensus shifts. In many cases, black swans aren’t really coming out of nowhere; they’re emerging from our blind spots, present but unseen. The dot-com bubble and the housing bubble are good examples of how that works.

Right now, we could be seeing this in the value of the dollar. After running up substantially, it is starting to decline. Of course, everyone knows that the dollar should be strong, and the consensus seems to be that it will resume its upward trend. But will it? This might be the next blind spot to watch.

Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.

© Commonwealth Financial Network

© Commonwealth Financial Network

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