Energy Prices And The Stock Market
- Savant Investment Group, LLC
- Jan 28, 2016
- 4 min read
Let’s start with some basic economic logic. Suppose the price of a product you regularly buy drops by 70% over an 18-month period. Is that good news or bad news? This commentary will focus on why that simple logic hasn’t shown up lately with respect to the stock market reaction to declines in oil prices, and what that means for your portfolio.
Question 1: Why have energy prices declined?
First a brief history. Throughout most of history, oil prices have been below $40 a barrel, and have only spiked above $60 a barrel five times – twice in the post-civil war period (we actually didn’t know that until we started researching this post), during the 70’s Arab oil embargo, during the mid-2000s (caused by a combination of low production and Chinese growth), and in the post-financial-crisis recovery (with concerns of supply caused by tensions in the Middle East). So part of the reason for the decline is that oil prices have never been higher than $50 a barrel for a consecutive period of time longer than five years.1
That answer alone is too simplistic. With respect to why the decline in oil prices is as large as it’s been over the past year, the following are also partial causes:
U.S. production of oil has doubled over the past 10 years
There’s been an increase of supply in oil substitutes, particularly natural gas
Unlike past situations in which prices have weakened, there’s a lack of cooperation among large oil producers (particularly Saudi Arabia) to reduce supply
The recent slowdown of growth in China have caused lower predictions of worldwide economic growth
Question 2: Why has the downturn of energy prices affected the stock market?
The basic logic that lower energy prices are good for the U.S. has held true statistically for most of the past – there’s been a significant negative correlation between energy prices and stock index values (on average, when energy prices fell, the S&P 500 increased in value).2 However, over the past year, that relationship has reversed – we posit a few reasons for this.
Oil prices have fallen so far and so fast, that the marginal impact on U.S. businesses of a further drop of oil prices is low – the fixed cost of conversion and transportation means that percentage wise, lower raw energy prices will be negligible on income statements
Since lower energy prices affect all competitors nearly equally, further reductions will be passed on to the consumer in the form of lower prices, which means corporate profitability won’t be affected – that is to say that lower energy prices are a good thing for U.S. consumers, but not necessarily corporate earnings
As the U.S. has become a bigger producer of oil and natural gas, there are more energy-specific U.S. businesses that are adversely impacted by the oil price decline – those declines will also have an impact on companies that service energy companies and their employees, including financial institutions and retail businesses
Correlations don’t always imply causality – as we mentioned above, the downturn in equity prices is in part related to lower expectations of global growth, which also impacts U.S. stock values
Question 3: What does all of this mean for my portfolio?
In our first quarter outlook, we stated that we expected 2016 to be a volatile year – unfortunately we were correct. Volatility tends to move both ways – large downswings and large upswings. During a time such as this, we never know the absolute low, and trying to time those lows has proven to be fruitless (the stock market has rebounded 2% since we started writing this). What we do know is how markets have reacted in the past. As of this moment, the S&P 500 has declined 15% over the past six months. We looked at all of the incidences over the past 90 years in which the stock market had declined by at least 15% over a six month period, and determined what return investors would have received over the next five years if they stayed invested in the stock market3:
The six-month 15% drop has happened 17 times4, so it’s far from a rare event (on average, once every five years). In 16 of those 17 occurrences, investors were rewarded for their patience by increasing stock market values. On average, the aggregate amount of the increase in value over those five years was 88% (which equates to a return of 13% per year).
What does this tell us? First, if you’re a long-term investor, you should expect events like this to occur occasionally. More importantly, on average, investors who’ve remained invested during a downturn have been rewarded by an above-average market return over the next five years. Recognizing that there is volatility in the market is a good thing – but now is NOT the time to react to that volatility by altering your allocation. A folk singer in the 70’s once wrote “changing horses in the middle of a stream gets you wet and cold.”
Notes:
1. Sources are the Energy Information Administration and Goldman, Sachs
2. Source is Savant Investment Group
3. Sources are Savant Investment Group and Markov Processes International
4. We only used non-overlapping periods – once we identified a six month period, we could not use another period until six more months had passed
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