Saturday, January 06, 2007

Oil Prices and Stocks: A Longer Term, Intermarket Look

In recent posts, I have looked at market regimes with respect to indicators and also vis a vis sector relationships. Now let's look a bit longer term and investigate a relationship between different markets: West Texas Intermediate (WTI) Crude Oil and the S&P 500 Index.

What has been interesting over the past six months is that we've had steadily declining oil prices during a period of steadily rising stock prices. Going back to 1983 (N = 5678 trading days), I found 660 daily occasions in which WTI was down by more than 15%, but the S&P 500 Index was up by more than 2% over the same six-month period. One year later (250 trading sessions), the S&P 500 Index was up by an average of 17.64% (619 up, 41 down), a much stronger performance than the average gain of 10.77% (4524 up, 1154 down) over that same period.

Of course, there were many overlapping periods during those 660 occasions. A specific look at the major clusters of occasions is instructive:

* August-September, 2003
* November - December, 1998
* January - August, 1998
* June - July, 1997
* March - April, 1997
* September, 1993 - March, 1994
* December, 1992 - January, 1993
* January - April, 1992
* February - July, 1991
* May - July, 1990
* September - November, 1988
* January - July, 1986

Note that some of these periods followed bear markets in stocks (2003, November, 1998, 1991, 1988); others occurred near the end of a market runup prior to a short (but sometimes stiff) market decline (August, 1998, early 1994; July, 1990). The 1994 period was perhaps most similar to the current market in that we had had rising stock prices for several years and a low volatility market environment. The late 1993/early 1994 period was the only one in which the S&P 500 Index was *not* higher one year after the oil price drop.

Overall, rising stock prices and falling oil prices have been supportive to equities. Even the sole period in which that wasn't the case, the 1994 correction, was relatively mild and led to significant price gains in the next few years. Conversely, in 2001 and early 2002, we saw falling oil prices *and* falling stocks, which signified overall economic weakness. One year later, stocks were even further in the red.

At present, we're seeing selling among the most speculative sector favorites from the recent bull market, including commodities, small cap stocks, and emerging markets. What recent history suggests, however, is that falling oil prices are, in the long run, supportive of the economy and the markets, limiting the duration and extent of corrections. Perhaps that is because falling oil prices also signify a tame inflation outlook, enabling the Fed to either ease rates or hold steady, providing a positive climate for borrowing and expansion.