John Mauldin on:
The Connection Between Oil and Stock Prices
"We find that changes in oil prices strongly predict future stock market
returns in many countries in the world... The impact of this predictability
on stock returns tends to be large."
They point out that there is a whole host of papers on the effects of oil
prices (especially shocks) and the economy. There has been little done
relating oil prices and stock prices.
I called Professor Jacobsen and am going to summarize their paper and our
conversation. First, let's look at what they actually analyzed.
Prior to 1973, looking at an oil price chart was boring. Things changed
very little form year to year, as the "Seven Sisters" (the large oil
companies) effectively managed oil pricing. Then, starting with the Yom
Kippur war, the chart looks like an EKG on crack cocaine.
They analyze the stock markets of 18 major countries (in local currencies)
and 33 emerging market countries. Using regression analysis, they compare
the stock price data with various oil price indexes (Brent crude, West
Texas Intermediate and Dubai) to see if there is any correlation.
It turns out there is. In 12 of the 18 countries, changes in oil prices
significantly predict future market returns on a lagging monthly basis. Not
surprisingly, a rise on oil price suggests a lower stock market and a drop
in oil price infers a rise in stock prices. The magnitude of the oil price
shift is also carried over into the magnitude of the expected
increase/decrease in stock prices.
They checked the model for various times, to see if there was an "outlier"
effect. By that we mean that the results could have been skewed because of
some events in one period of time. The rest of the time there was no
correlation. That does not seem to be the case. In any event, the effect is
stronger in the later years.
What about the normal ebb and flow of the market and oil? We know that oil
tends to rise in the summer as gasoline demand increases. We also know of
the so-called "Halloween" effect or the May-September bias in the market.
(Selling in May and buying in October is a known seasonal effect which can
produce increased returns with lower volatility over time.) They also
checked the January effect. Statistically, at least, you could not explain
the correlation between stock and oil prices by those two factors.
The study then looks at whether you can use the price of oil as a "market
timing" tool. The answer is that in many countries you can. Basically, the
method they used had them either being long the market or in cash. While
their methods were not intended to be a sophisticated timing model but
rather a general indication, it is clear that paying attention to the price
of oil can "add alpha" on returns over buy and hold. In some countries it
tends to be quite significant.
I sent the paper to fellow analyst Greg Weldon, and he wrote the following
in his letter this morning:
"Of specific interest from OUR perspective, are several conclusions:
* Asia tends to be more insulated from oil price shocks, than Europe, by a
factor of nearly 2-to-1, with Germany, Switzerland, Italy, Sweden, and the
Netherlands being more vulnerable ... against which Japan, Singapore, and
Hong Kong are LESS vulnerable, stock-market wise.
* The United States is the second MOST 'vulnerable', in terms of the
potential negative influence on the broader stock market, via rising oil
prices ... second only to the Netherlands. Further, within the dynamic as
influences the US stock market, we note the following conclusions reached
by the report:
* Cyclical Services are MOST negatively influenced when oil prices rise.
* Cyclical Consumer Goods are second most negatively influenced.
* Financials ... third most negatively influenced stock market sector.
"Indeed, there is BUT ONE macro-conclusion to be reached as a result of
THEIR macro-sector conclusions ...OUR ORGINIAL thought process is
VINDICATED ... as CONSUMER DISCRETIONARY spending takes the biggest hit.
And thus it is ... amid LOW Savings, and ERODING income, and RECORD debt,
that the US consumer is MOST vulnerable, at this moment in history, to
rising oil prices."
(Greg has finally gotten some help. To learn more about his letter you can
email weldonfinanical@comcast.net)
Let's look at the conclusion (and important question) the professors offer:
"We find strong evidence that changes in oil prices forecast stock returns.
This predictability is especially strong in the developed markets in our
sample countries and the world market index... and is robust over time and
cannot be explained by [other market effects]. While one might expect that
this predictability is related to the size of specific sectors in different
countries we find this is not the case. The predictability tends to be
country specific. This suggests that this is a macro economic phenomenon.
"It might be that this predictability is related to a lagged reaction of
the market to the general impact of oil price changes in the different
economies... But even if we are able to determine the source of the
predictability, we have not idea why the financial markets react so slowly
to this information in the oil price. That remains the real puzzle to be
explained."
Now, before I sound too breathless, let me point out that this method,
while adding alpha or excess returns over buy and hold, is still volatile
as heck (that's a technical term) and is wrong over 40% of the time in most
countries. It is just that when it is right, the returns are excessive.
Which also means that there could be certain random entry/trend following
variables, about which the professors would obviously not agree. To use
this system you would have to be a very disciplined trader. It is probably
more useful as something to keep an eye on than as opposed to using the
system as a rigorous model.
But even given those caveats, the study clearly show that oil prices and
stocks, especially if there are big moves in oil, tend to go in opposite
directions.
The Effect of Oil on Muddle Through
From some time, I have been thinking the price of oil should come down. We
all know the propensity of OPEC members to cheat. Indeed, only Indonesia
and Venezuela are currently producing under quota, and not for lack of
trying to cheat. OPEC is currently producing 1.22 million barrels of oil
per day above their quotas. That is HUGE.
Every major oil producing region increased production in November. Iraq
brought on more supply and is bringing on more if they can get the security
on the oil pipeline fixed.
The world is awash in a tidal wave of oil. If you had asked me a year ago,
given such production, where I thought the price of oil would be, I would
have said down. In fact, if I go back and check the record, I probably
predicted a drop in oil prices for this year. If I did not, I certainly
privately thought so.
World wide demand is up as a recovery starts to manifest. The Wild Card?
Can you say China, boys and girls? Marshall Steeves, oil analyst for Refco,
told me that strong demand, especially from China and the US is pushing the
price of oil up. Supplies are quite tight, he notes. Weldon tells us (where
does he get his stats?) that refinery production capacity is at 94% and in
California it is at 97%, even as the supply of gas in California is
dropping. That is well above seasonal averages.
It is not just the price of gasoline. Heating oil prices are up and
supplies are down. Natural gas is through the roof. In fact, I got this
email from a public oil company executive today:
"You are a big proponent of hedge funds, but I'd like to know your thoughts
on how the "hedge funds" (I hate to lump all together, but bear with me
please) are apparently creating extraordinary volatility in the commodities
markets (NYMEX), particularly natural gas. It appears that the pure
speculative players are making a mockery of what the markets are to provide
to users & sellers...that is a place to hedge actual use of product, be it
selling or buying.
"It seems the speculators are only looking for movement, driving the prices
up and down dramatically from day to day, mostly on the hype of the day,
and totally without regards to any actual use. Further, it appears a large
contention of speculation is coming from hedge funds.
"As a producer and user of natural gas (and crude oil), it is sickening to
see so much activity and control of pricing in the hands of manipulative
gamblers. Am I being too harsh on the hedge funds that engage in this
commodity speculation? Thanks. Your writings are always interesting and
insightful."
Frankly, Ken, I wish we could lay it at the feet of traders and hedge
funds. Unfortunately, that is not the case.
Just like in oil, there is a clear trend of dwindling surplus supply in
natural gas for the last six weeks. Traders and hedgies can clearly move
markets in the short term, but supply and demand will win over time. The
"specs" (speculative traders) simply add liquidity to the market. They are
not large enough to move the market for more than a short period. And when
there are violent swings, far more often than not it is from emotion and
systematic driven trading than from the ability of funds to actually create
any long term effect.
If we want the price of Natural Gas to go down, the answer is simple.
Figure out how to produce more or reduce demand. If you are looking for
blame, I would suggest our lack of a coherent national energy policy and
over-regulation is far more of a factor than a few traders. We could cut
gas demand by a huge factor whenever we want. We simply have to allow (and
encourage) nuclear production of electricity in places besides Iran and
North Korea. Or if you are of a more green persuasion, fund renewable and
alternative sources of power. But that's a different letter.
The Oil Tax
In my discussion with Professor Jacobsen, as he was looking for a possible
"transmission" mechanism for the relationship between oil and stocks, I
suggested that he look at the effect of oil prices on consumer spending.
Money spent by consumers on oil is not spent on other goods and services.
That squeezes profits and sales on a host of businesses. It also increases
the production and transportation costs of businesses, creating a double
whammy on profits.
What did Greg note above? The stocks of cyclical services and cyclical
consumer goods were the two areas most negatively affected by rising oil
prices.
And now we come to the heart of the problem. If oil and energy costs
continue to rise, this study suggests that the stock market could be in
trouble over the next few months. Is it a perfect predictor of a drop? No.
But it is just one more factor weighing on a market which is already at
nosebleed valuations. Carl Swenlin (www.decisionpoint.com and one of my
favorite sources for charts) shows that on a trailing basis, the S&P P/E
ratio is now over 30, on a GAAP reporting basis. That is almost double the
long term historical average.
As I noted last week, this economy is stimulus driven. Rising energy prices
counter that stimulus. Indeed they are negative. Given that most countries
are producing all the oil they can, it is hard to see where a significant
increase in production is going to come from. Perhaps Saudi Arabia could be
persuaded to squeeze out a few more barrels, but they are already running
significantly above quota. Now, OPEC thinks demand will soften next year
and Marshall Steeves thinks things might balance out, so a major rise does
not seem likely (barring the ever present danger of a terrorist attacks,
political unrest in Nigeria or Venezuela or any of the dozen odd places
with lots of oil and poor populations).
But it also suggests that the stimulus I was hoping would come from a major
drop in oil prices is becoming more of a wish than even a mere hope.
The Dollar and Oil
Note: Oil is priced in dollars. Europeans have not seen a rise in oil
prices. Indeed, they have seen a significant drop in recent years. Those
countries who have competitively devalued their currency against the dollar
have seen their oil rise in price. How long before the rise in oil price
becomes a real deterrent to growth and they are forced to let their
currencies rise?
Some of the major buyers of dollars like China, Hong Kong, and Malaysia are
pegged to the dollar. Other countries like Korea, Thailand, Taiwan and
Singapore have hardly moved, aggressively keeping their currencies in check
so as to be able to sell to the US consumer. This means they pay a double
price for keeping the currencies low: they buy depreciating dollars and are
forced to pay higher energy prices. |
