PMC Weekly Review - June 30, 2017
A Macro View – The Crude Reality: Do Oil Prices Predict Market Returns?
When the Organization of the Petroleum Exporting Countries (OPEC) meeting concluded on May 25 this year, oil prices finished down nearly 5% from their previous close. The sharp drop was due in large part to disappointment that production cuts did not go further. OPEC agreed to continue its previously pledged cuts of 1.8 million barrels per day for another nine months. However, the following day crude oil rebounded from the fall, and US West Texas Intermediate (WTI) crude futures finished up almost 2%, but still closed under $50 a barrel. Although the price of oil is up from its low of under $27 a barrel in 2016, it is still a far cry from its high point of around $160 a barrel in 2008. Yet, simultaneously, the S&P 500 continues to reach all-time highs. So what can be inferred from the relationship between the price of oil and stock market returns?
Since 1990, the correlation between the WTI and the S&P 500 has been around 0.56, indicating that as one increases, the other generally does as well. However, since 2014, when the price of oil fell significantly, the correlation has become negative, and the stock market continues to set new high records, while oil continues to fall from its high water mark. This is not the only instance where oil prices and stock market returns have decoupled. Low oil prices helped to precipitate the dotcom boom in the late 1990s, and oil remained high for a short period as stocks plunged after the financial crisis in 2008.
Generally, when oil prices dip, investors worry that there is less demand, ultimately indicating a slowdown in overall economic growth. Another concern they have is that domestic producers will default on their loan payments, hurting banks that have provided loans to oil-related companies and further dragging down the economy. However, in the current environment, the consensus remains that low prices have more to do with the supply side, as global demand for oil continues to increase around 1.3% annually. After an uptick in American shale oil production, OPEC responded by increasing production to retain market share. OPEC also has issues with its ability to enforce production cuts on its member nations: Its current pledged agreement to cut production doesn’t even include Libya or Nigeria, who account for 7.1% of OPEC’s production. After American production slowed in 2015, the industry as a whole reorganized by improving technology and becoming more efficient. Ultimately, much of the US oil industry became profitable, with oil prices under $50 a barrel, and continued to add to the world’s supply, which in turn has kept prices low.
Concurrently, the stock market has continued to make gains alongside low oil prices, due in part to the weight that energy companies carry within our economy. After oil prices dropped precipitously in 2008, the Energy sector consolidated and currently constitutes 6% of the S&P 500, much less than the 15% weight it had before the decline. Energy is a main cost of almost any production, and although low oil prices have been harmful to energy companies, low oil prices have benefited the main driver of the American economy, consumers. Low oil prices have essentially served as a tax cut for much of America, allowing more dollars to flow to other economic sectors.
So what does all this mean for using oil prices as a proxy for the US economy? It’s hard to point to any single indicator to predict where the market will go; not only are sectors intricately intertwined, but a multitude of factors coalesce to determine market performance. As we have seen, despite a positive historical correlation between oil prices and market performance since 1990, market performance depends heavily on the time period being reviewed. Technological advances, increased efficiency, smaller market representation, and an increase in global production and supply all seem to have the energy sector in a transitional period. Regardless, it appears low oil prices have become the new norm, which should continue to benefit many areas of the economy while harming others, further complicating the relationship between oil prices and stock market returns.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2017 Envestnet. All rights reserved.