Correlation of Oil and the S&P 500 is About to Deliver Hope
Notes on the direction of oil and the equity markets: New data suggests that the demand for oil may not be rolling over, but rather, stabilizing (in the midst of normalized volatility) along with the equity markets. Could we be moving higher by May? While no one knows if the low for oil has yet been reached in 2016, it now appears that the downside risk has begun to loom less large; that means upsides for both oil and the economy may be shortly at hand.
Highly-focused research and new data also suggest the oversupply of oil may begin to abate by May. Meanwhile, it appears non-OPEC oil supplies have peaked and are now declining. While the declining probability of a recession could take demand down further, the increasing probability of expanding economic growth will reduce supply and indeed bring into question previous supply estimates that now appear too high. More importantly there is no sign that oil and gasoline demand is declining. Rather, consumer demand strength is driving the data, suggesting crude stocks should begin to draw (sharply) in May, if Credit Suisse research is right.
Earlier this year, the narrative became that surely a recession must be imminent. A key contributor to this scenario was the sudden falling demand for gasoline in the U.S. However, since late January and February, the demand for gasoline has been rising. Early indications for January also show that demand for gasoline in China, the EU and India was growing robustly. Credit Suisse analysts now project 600,000 barrels per day of world demand growth in 2016, slightly lower than the 750,000 barrels per day of demand growth in 2015.g
While the supply side of inventories may continue to grow on the short term, causing the possibility of further weakness in the price of oil by May/June, Credit Suisse analysts expect to see a drawdown in crude stocks and possibly at a sharp rate. Here is the near-term demand and supply chart for crude oil stocks according to Credit Suisse Research:
Evidence of year-over-year declines in oil output in the U.S. and throughout South America.
Moreover, the chart below suggests the importance of the price of oil given the tight correlation between the direction of the S&P 500 and the price of oil. The blue line represents the S&P 500. The red line is the price of iShares US Energy Index. Why the tight correlation? Many analysts point to the importance of the oil and gas industry to the industrial economy in the United States including steel, pipe, drilling equipment, field services, exploration labor, financing, transportation, and storage.
Year-to-Date High Correlation: 2016
Year-to-Date Comparison Charting Using an S&P 500 and U.S. Energy Index ETF
Bottom line: As long as the tight correlation between the S&P 500 and the price of oil holds, the probability of stabilizing oil prices, and the prospects of $40 per barrel of oil by year-end, suggest that we may have seen a bottom for both oil and the S&P 500 for the year 2016…and just when we could all use a little hope…after two back-to-back, peak-to-trough, 14% market corrections (two is highly unusual). If the bottoms (price of oil and the S&P 500) have been reached, congratulate yourself; hanging in there is not always easy, even when you understand the equity risk premium only goes to those willing to participate in the market’s gyrations.
Vaughn Woods, CFP, MBA
Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter may not reflect the views of Bolton Global Capital or Bolton Global Asset Management. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0212
Global Equity Strategy, Oil: why it remains one of the key drivers of risk and how to play it: February 11, 2016, Andrew Garthwaite, et al.