Tags: Oil | Prices | Stocks: | Clear | Relationship

Oil Prices & Stocks: No Clear Relationship

Friday, 08 April 2005 12:00 AM

Ask a financial journalist writing about the stock market. He/she will tell you it all seems to boil down to a simple formula.

To calculate the daily shift in the major S&P 500 index, simply take the change in the price of oil and compare it to the price at the pump. If they are both higher than they were two days ago, deduct the net change from the value of the stock index.

Ask a financial journalist writing about the stock market. He/she will tell you it all seems to boil down to a simple formula.

To calculate the daily shift in the major S&P 500 index, simply take the change in the price of oil and compare it to the price at the pump. If they are both higher than they were two days ago, deduct the net change from the value of the stock index.

Add a headline like "OIL SURGE BEATS BACK STOCKS" and you've got yourself a story.

This must be true, based on the amount of pre-market e-mails, streaming headlines and market summaries one sees throughout each day.

If the price of crude rises, sell stocks. But is the relationship that clear cut over time?

chart

Well, we took a look at data from November 1986 through November 2004 to see what conclusions we could draw about the raging price of crude oil and its impact on the stock market.

In the above graphic, the yellow line represents oil using the right scale. The pink line measures the S&P 500 index on the left scale. Throughout the entire timeframe there is a rather feeble 46% correlation holding the two lines together.

In other words, the price of oil drives the direction of stocks less than half the time. The conclusion? This seems to be a pretty meaningless relationship.

So what's the theory behind this story?

We see that as the economy recovers from recession, the stock market rises. Consequently, the bull run inevitably starts to look tired, leaving the market vulnerable to short-term correction.

As global demand picks up, basic material prices begin to rise. That includes anything from construction materials to aggregates you'd find at any industrial plant – coke, iron ore, etc. It also includes oil.

As factories pick up steam to meet slowly rising demand, they need more resources – including labor and fuel for energy.

More workers mean more wages and more spending, and that makes the overall economy look brighter. This is precisely what has happened in the Far East, where China is gobbling up oil and other raw materials to feed the roaring dragon.

So soaring energy prices and accelerated consumer spending go hand in hand. While this seems like an ideal situation, the problem is investor psychology.

The question is: Can investors bare the strain of ever-increasing oil prices based on the theory of the consumers' ability to continue spending for goods?

Investor worries about the impact of rising crude might simply be an illusion. Just before the U.S. presidential election last year, oil hit what was then a record -- $55.65.

At the time, stocks were gearing up for a major move and the price of oil was just one factor holding them back. After the oil pop and the Bush re-election, stocks went on to score another high for the year. That was before oil recoiled for its next rally. But that surge buckled before oil hit a new high of $58.20.

Because consumer spending makes up roughly two-thirds of economic activity, analysts factor the fluctuation of oil into every facet of the consumer's life cycle.

The day-to-day grind becomes more costly as we spend more on gas – which impinges on our ability to purchase other goods. Summer driving season becomes more costly, so families are forced to rethink that cross-country Winnebago vacation.

Alternatively, the cost of air travel is also pushed higher due to fuel surcharges. Our fuel bills at home increase, again forcing us to choose over discretionary spending. And the cost of foodstuffs rises as chemical costs have increased.

In short, the prices of many goods rise at the same time, as commodity prices are often closely linked due to the declining dollar.

That brings us to inflation, which might well need to be addressed by the Federal Reserve through higher interest rates. In fact the Fed has already fired a warning shot about the potential for rising inflation.

But consumers must concentrate on answering the simpler question: Will the consumer ultimately be pushed over the edge as the price of oil rises?

Unfortunately, investors are prone to constantly discount. And that means we will have to continue to endure those repetitive headlines linking oil and stocks.

But in truth, the relationship between oil and stocks isn't all that strong.

Even if we shorten the range from our near-20-year graphic to more specific instances, the picture remains ambiguous. Take the three-year period following the first Gulf War between October 1990 and December 1993. The correlation between oil and stocks was at 77%.

For the two years between November 1996 and December 1998, the relationship was much stronger at 89%. But these were negative correlations. In other words, the falling price of oil could have contributed to the stock market rally.

Of course one might expect that a decline in the price of oil might boost the stock market. If you are a commodity bull and a stock market bear, you are convinced that oil will hurt stocks. But the evidence simply isn't there.

The bottom line is that firm commodity prices are the result of a strengthened global economy. Not only is that good for corporate earnings, but we hear more and more companies talking about successfully padding their margins. This tells us that when it comes to paying up, Joe Average isn't as sensitive as fretful investors would have us believe.


Making Money

Buy-and-hold investors are probably losing their minds as oil perpetually makes the headlines these days.

In times like these, investors might want to have a look at buying call options on the NASDAQ. It is common knowledge that tech stock sensitivity is closely linked to the prospects for the overall economy.

Take a look at the lower boundaries of the recent trading range for the NASDAQ index and as you see the whites of sellers' eyes, make a speculative play on a sustained bounce. Buying options is risky, but in this case you can determine your overall dollar amount of risk at the start.

Energy bulls have found a nice vehicle in the Oil Service HOLDRS Trust ETF (OIH: AMEX) to harness the power of the bull run for oil.

This fund reflects shares in major oil and gas service corporations – including Halliburton Co., Baker Hughes Inc., Transocean Inc. and Schlumberger Ltd. You can buy or sell short many ETFs just like shares through your broker. So far this year, this fund has increased in value by 17.9% at a time when the S&P 500 index has fallen 2.6% and the technology-heavy NASDAQ composite index is nursing 8.2% losses.

For intrepid investors who want to take a walk on the wild side – whether bullish or bearish on oil prices – options on OIH shares are available.

With the Oil Service HOLDR trading at around $97.85, a call option expiring in May would cost $300. If the OIH jumped to $100 within the next two weeks, that call would be worth $375. One of the major benefits of options investing is that your capital is leveraged. The 2.2% increase in the price of the underlying shares (in this case the OIH, as we assume it moves to $100 per share) has resulted in a 25% gain in the value of your option.

That affords you leverage of approximately 10 times your purchasing power through simply buying stocks. But be warned: Options trading does come with the added risk that if the trade doesn't go as planned, you could lose your capital. Options are a valuable tool, but only use risk capital that you can afford to speculate with.

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Ask a financial journalist writing about the stock market. He/she will tell you it all seems to boil down to a simple formula.To calculate the daily shift in the major S&P 500 index, simply take the change in the price of oil and compare it to the price at the pump. If they...
Oil,Prices,Stocks:,Clear,Relationship
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2005-00-08
Friday, 08 April 2005 12:00 AM
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