Yesterday, oil was an economic indicator promising prosperity. Today, oil is the biggest scapegoat around.
On December 22, 2010, the following headline graced the Wall Street Journal: “Oil back at $90 as growth gains pace.” The commentary expressed this upbeat message: “The recovery in oil prices is an encouraging sign of world growth.”
Triggered by the glaring disconnect between fact and financial reporting, I felt compelled to comment on the obvious danger of rising oil prices (see article "Rising asset prices cannibalize U.S. growth").
Even the media has caught on by now. On March 1, Reuters ran the following article: “Wall Street slammed as oil fuels recovery worries.” The commentary was less upbeat: “Stocks dropped as investors worried that rising oil prices could choke the economic recovery.”
Rather than squeezing facts into a mold to fit financial reporting, let’s take a look at the real correlation between oil and stocks.
The Real Correlation Between Oil and Stocks
The general wisdom is that rising oil prices hamper the economy and/or stocks. But that’s only true to a certain extent. Since 2009, the price of crude oil tripled while the S&P (SNP: ^GSPC) doubled. High oil didn’t seem to affect The S&P. The Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) didn’t seem bothered much by rising oil either.
It is only after oil surpasses a certain undefined and ever changing "pain threshold" that all of a sudden oil turns into a killer of economic activity.
To a certain extent, high oil prices contribute to high stock prices. The energy sector accounts for 13.10% of the S&P 500. As oil prices go, so go energy stocks and a strong energy sector can boost the overall market’s performance.
Again, there comes a point when the backlash of rising oil prices trumps the boost from the energy sector.
What about Falling Prices
Thus far we’ve talked about rising prices. How do falling oil prices affect the economy? In 2008 oil topped at $147 a barrel. When oil rolled over, the S&P traded around 1,400. Over the coming year oil prices tumbled nearly 78%.
According to Wall Street’s logic, stocks should have gone through the roof. The ETF Profit Strategy Newsletter bucked conventional “wisdom” and predicted a decline of all asset classes across the board.
Along with oil, the S&P went on to lose an additional 50% while the commodity sector got more than cut in half.
This phenomenon of lock-step behavior by asset classes that normally boom and bust at different times, has been a common theme since the 2007 market top. Will it occur once again in 2010?
General Trading Tips
Oil is a tough market to trade. Geopolitical developments can void an otherwise solid set up.
Oil linked ETFs like the United States Oil Fund (NYSEArca: USO) and iPath S&P GSCI Crude Oil ETN (NYSEArca: OIL), often suffer from contango and do not fully replicate oil’s performance. Case in point, since 2009, USO and OIL doubled in price while oil prices tripled.
Another way to gain exposure to oil prices is by betting on the energy sector. The Energy Select Sector SPDR (NYSEArca: XLE) is the biggest broad energy ETF, but it is not alone.
Some focus on oil and gas exploration (NYSEArca: IEO), others on oil equipment and services (NYSEArca: XES).
But buying oil stocks comes with exposure to the same kind of risks and perks as buying any other stocks, whether it’s oil stocks, gold (NYSEArca: GLD) or financial stocks (NYSEArca: XLF).
Regardless of your bias, beware of headline-based buying. More often than not, when the financial media exacerbates a trend, it may not go on for too much longer.
Sunday's ETF Profit Strategy Newsletter includes a technical forecast for oil and stock prices along with the "oil price pain threshold." This threshold indicates when high oil prices will prohibit rising stock prices. |
