Lower oil prices are supposed to be good for the economy and stock market because they provide consumers and businesses with more money to spend. But since early November, oil prices and stocks have been moving lower in lockstep, and there’s no telling yet when that might end.
Year-to-date the S&P 500 is down 7% while oil prices have fallen 17.%.
“At this point oil is a one-stop shop indicator for stock prices,” says Nick Colas, chief market strategist at Convergex. “That’s frustrating. It’s almost like we’re beholden to this one commodity.”
More specifically the stock market has been “treating the plunge in oil prices as an indicator of global growth,” says Russ Koesterich, global chief investment strategist at BlackRock. “That’s wrong. Oil is a cyclical commodity. The problem is not [global] demand. The problem is supply.”
If that’s the case, the plunge in oil will end only when and if producers like Saudi Arabia and Russia slow production, but there’s no sign of that happening yet.
If, instead, the plunge in oil prices is a signal of a continuing global slowdown, and possibly recession, the decline will continue, dragging stocks down with it.
But there are other analyses, which are not as damaging for the broader stock market.
“Deteriorating sentiment rather than actual fundamentals “are driving stock prices lower,” says Koesterich.
Jim Bianco, president of Chicago-based Bianco Research, said, “Crude oil has become a credit event as opposed to a consumer event…a big credit event the financial sector has to deal with. … Banks lent the energy patch billions of dollars and at $31.50 per barrel of crude many are not getting their money back… At around $30 or lower a barrel there will not be residual value left” for many oil companies.
That credit analysis may explain in part why the KBW Bank index is down more than 16% year to date while the SPDR S&P Oil and Gas Exploration & Production ETF (XOP) is off 12.26% and why the broader market indexes keep falling. Financial companies make up 16% of the S&P 500; energy stocks just 6.6%.
Banks, however, are also under pressure from a flattening yield curve. The difference between the rate they can charge for loans and credit cards and what they pay on deposits is narrowing, impacting revenues, and expectations that the spread could widen are fading because the market now anticipates fewer Fed rate hikes than previously expected.
Given the continued linkage between stocks and oil prices and no signs that oil prices are stabilizing, what should investors and advisors do?
Koesterich recommends they “de-emphasize momentum, focus on quality in a portfolio and buy funds designed to mitigate volatility.”
The Vanguard Global Minimum Volatility Fund (VMVFX) and iShares MSCI USA Minimum Volatility ETF (USMV) are each down just 2% year-to-date, about one-third less than the S&P 500. He also recommends preferred stocks as yield-generating assets that can substitute for ailing high-yield assets. “Oil prices can continue to fall and drag stock down,” says Koesterich, “but at some point if all that is driving stocks down is oil, then the selling is exaggerated.”
In the meantime, Bianco recommends that investors “stay away from financials and oil stocks” and be wary of manufacturing and shipping stocks. They are “next weakest sectors” and tied to the decline in the broader commodities market.
Colas recommends that advisors make sure their clients are invested in a diversified basket of financial assets, especially advisors serving clients in Texas or elsewhere whose sources of income are closely tied to the oil patch.
A year down the road, the outlook is brighter. “”There is a lot of history and supportive information to suggest that following the oil prices shock, the U.S. economy will be more robust,” writes David Kotok, chairman and chief investment officer of Cumberland Advisors in a recent report. “The rebound will be reflected in an upward movement in stock prices and higher total returns.” He cites a Hartford Funds study that shows the S&P 500 gaining an average 27% total return one year after four massive oil price drops of 50% or more since 1985.
No matter what, “until oil prices bottom stocks will be volatile,” says Colas.
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