The drop in oil has been fierce and comes amid an economic slowdown in China and a concerted effort by OPEC to maintain low prices, in a bid to compete with the booming US shale market.
Article Updated 12.22.14
Naturally, some commentators see the drop in oil as a precursor to a period of poor performance in stock markets. After all, stock markets are near to all time record highs and expensive according to several measures.
Furthermore, crude oil and stock market prices often fall in tandem, as we saw during the financial crisis of 2008-2009.
However, this time around stocks have so far remained resilient despite the 50% drop in oil.
It is therefore not obvious what the effect of low oil prices will be on the stock market. Though as we shall see, there is evidence to suggest that low oil prices are good for stocks.
Crude oil and the stock market
The current plunge in oil is making all the headlines so I thought it would be interesting to see if any studies had been done to see how oil affects stock returns.
Thankfully, the research website Quantpedia was able to point me towards an interesting study that does just that.
The paper, Striking Oil: Another Puzzle, authored by Driesprong, Jacobsen, and Maat, analyses 30 years of monthly stock market returns and finds that changes in oil prices can indeed predict stock market returns around the world.
In very simple terms, the authors found a significant correlation between higher oil prices and lower market returns. Meanwhile, lower oil prices usually led to better stock market returns. The authors also found that there was some degree of lag between the change in oil prices and the subsequent change in stock prices.
Knowing this information I decided to do some more research on the matter and I came to a similar conclusion.
1-Year Returns in Oil and Stocks
In the table below, the annual returns for WTI oil between 1960 and 2013 are shown against the subsequent 1-year returns for the S&P 500 Index.
In other words, in 1960, the price of WTI crude fell -3.21% over the year. The following year (1961) the S&P 500 climbed 26.64%. In 2008, the price of crude fell -41.25% and the following year, the S&P 500 rallied 25.94%.
As you can see from these results, there were only five instances where oil prices fell and then the S&P 500 fell in the subsequent year; 1961, 1968, 1980, 2000 and 2001.
In 2001 for example, WTI oil dropped -2.50% and the S&P 500 fell -21.97% the following year.
The following chart illustrates the results in better detail:
As you can see, there is a clear relationship between higher oil prices ( x axis) and lower stock returns (y axis). Similarly, lower oil prices point towards higher stock returns.
In fact, if we follow the line of regression we could say that this year’s 50% drop in oil is pointing towards S&P returns of around 25% next year.
Will stocks rise 25% next year?
There are many factors that could affect how stocks will perform next year and the price of oil is just one. So buying the market based off this simple study is probably not advised.
However, lower oil prices should help the economy and give the average consumer a bit more cash in their pocket. That’s a good omen for stocks so lower oil prices should be regarded as a positive factor for the stock market next year.
Another question, therefore, is when will oil prices hit a bottom?
Will we see $40 oil?
Some analysts are now calling for $40 a barrel and believe we are witnessing a game-changing shift in global demand that will change the outlook for oil forever.
Personally, I do not take that view. I see $40 a barrel as the very lowest that oil could get to in the short term but in the end I do not expect it will get there.
The cost of production for most oil producing nations is around $100 a barrel which means any lower than $100 and there is no profit to be made. As a result, many oil companies will go out of business and oil supply will drop substantially.
As they say, “the cure for low prices is low prices”.
And it should also be remembered that there are less than 40 years left until oil runs completely dry.
Will stocks follow oil prices lower?
The other question is whether or not a global slowdown will see oil prices and stocks fall together, like they did in 2008.
So far we have not seen that happen. Stock markets threatened to drop in October but then rallied back to new highs.
Like oil, the stock market is a leading indicator into the future of the economy so if it were the case that we were headed for a significant slowdown, the stock market would have dropped too.
Instead, stocks have soared and oil has dropped and the spread between the two has reached it’s highest level since 2004.
It may be unusual to see oil fall so heavily while the stock market remains strong but this is what is happening. And because of this, it could be argued that much of the fall in oil has been artificial.
OPEC’s refusal to cut oil production took markets by surprise and this intensified selling pressures. Oil is a particularly volatile commodity anyway, so in some ways it is no surprise to see it drop 40, 50, or 60%.
And as the following chart shows, oil is now trading right on it’s 200 month moving average.
This line has proven to be an excellent place to buy, both in 2008 when oil hit $30 a barrel, and 2001, when it touched $21 a barrel.
And if the evidence from Quantpedia and this article is to be believed, with oil down so heavily, it may not be too bad a time to buy the stock market either.
Where to put your money?
Since low oil prices may help stocks next year, there should be plenty of opportunities for investors to take advantage.
With this in mind, I decided to test the annual performance of different sectors after a year of negative oil.
The following table illustrates the annual returns of 8 sectors when the previous year has seen a negative price return in WTI oil and these results go back to 1994:
— This section of the article was updated on 12.22.14 due to a calculation error in the first draft —
The best sector to be invested in after a year of negative oil prices according to this analysis is the automobile sector, which has an average annual return of 42.19% following a year of negative oil. However, this sector was also volatile, dropping -33% in 2002, and -22% in 2007. In 2009, the sector returned a staggering 175%.
– It should be noted that 2007 saw a rapid increase in oil prices while 2009 only saw a modest recovery. This could suggest that the automobile sector will do well next year, so long as oil prices do not climb too aggressively.
The oil and gas sector, represented by the Dow Jones Oil & Gas Index, and basic materials, represented by the Dow Jones Basic Materials Index also performed strongly.
The worst sectors to buy according to this analysis are banks and real estate. Investors may also wish to stay away from airlines which have seen a huge run-up in 2014.
Note: This test could be extended to include more sectors, I have just included the most relevant.
For Premium Data users, the ticker symbols for these sectors are as follows:
SPY = SPY
DJ Airlines Index = $|DJUSAR
DJ Oil & Gas Index = $|DJUSEN
DJ US Automobiles Index = $|DJUSAU
DJ US Bank Index = $|DJUSBK
DJ US Basic Materials Index = $|DJUSBM
DJ US Consumer Goods Index = $|DJUSNC
DJ US Real Estate Index = $|DJUSRE
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