Prepare for Dow 12,000 if Oil Shock Shakes Market

While the prospect of an oil supply shock is not a Citigroup report’s ‘base case,’ the ramifications of this ‘fairly fat tail risk’ would be ugly

Citigroup analysts fear an oil shock is possible, if unlikely. Citigroup analysts fear an oil shock is possible, if unlikely.

There are a lot of charts in Jeremy Hale’s strategy report today, not to mention a cute illustration of eggs representing various asset classes nestled together in one basket.

But if you are the type who can’t enjoy fresh records in stocks without something to worry about, then “Figure 12. Backward Sloping Theoretical Supply Curve” is the one for you.

As anyone who’s taken an Econ 101 course knows, charts of supply are supposed to look like the ascending portion of a rollercoaster. They slope upward from left to right as rising prices on one axis push output higher on the other. However, if you’re riding the rollercoaster in Hale’s report, make sure your lap belt is nice and tight because you will be darn near upside down by the end of it.

What Hale and his colleagues at Citigroup Inc. are depicting is a theoretical “oil shock,” in which supplies decline even as prices continue to move higher. While the prospect of a supply shock is not the strategists’ “base case,” neither is it “non-negligible” as tensions in the Middle East escalate. The ramifications of this “fairly fat tail risk” would be ugly: oil supply shocks in the past have caused equities to drop 30%, according to Citigroup. That would drag the Dow Jones Industrial Average (INDU) to below 12,000 and the Standard & Poor’s 500 Index to under 1,400.

Supply Shocks

Treasuries may not be safe either. Bonds declined more often than not during supply shocks in the 1970s because the market was more concerned with inflationary pressures than finding havens, according to Hale.

The market is currently saying that the threat of a supply shock is not acute. Oil has lost about 2% from its nine-month high on June 20. Yet the unstable situations in Iraq and Ukraine have placed a supply disruption at the top of an equity-market worry list that has shrunk so much it’s a cause to worry for some. At about $105 a barrel, prices are “well within the ability of the U.S. economy to absorb,” Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, said in a June 30 note.

Domestic Boom

At what price oil begins to become a drag on the stock market is open for debate. So far, energy has proven to be a net positive on equities in the U.S., a nation experiencing a boom in domestic production. Oil and gas producers led the S&P 500’s rally last quarter, rising 11 percent as a group. Profit for the industry is forecast to have risen almost 10% in the second quarter, nearly double the S&P 500. Almost $6.9 billion has flowed into exchange-traded funds tracking energy stocks this year, the most of any industry group.

Energy companies -- as well as industrial and technology stocks -- tend to lead gains during the latter stages of bull markets, so investors should position themselves accordingly in the second half, according to Andrew Burkly, head of institutional portfolio strategy at Oppenheimer & Co.

Meanwhile the group that led the five-year bull market, the consumer companies that depend on the cash shoppers have left over after filling their gas tanks, have turned into the weakest performers, up only 1% in 2014.

Like it or not, there’s a new group riding in the front car of the rollercoaster that is the U.S. stock market, even if it has transformed itself into what they call a “slow ride” at Disney. Best to keep that lap belt tight anyway.

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Check out Grantham: Big Stock Bubble ‘Will End Badly’ in 2016 on ThinkAdvisor.

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