6 Degrees Of Separation Between Rising Oil Prices And Declining Stock Prices

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Includes: CWI, OIL, SPY
by: Lawrence Fuller

Summary

A rise in oil prices is increasing the bullish sentiment towards stocks.

This relationship is a fallacy.

In six steps I will show why a continued rise in oil prices is bearish for the overall stock market at this time.

Six degrees of separation is a theory which states that through just five or fewer people anyone on the planet can be connected to anyone else in just six steps. The math assumes that all five people know at least 44 people, and that each of these people know an entirely new group of 44 people, and so on, which after six steps of multiplication connects you to any of the more than seven billion people on earth.

These are mindboggling numbers that I have trouble conceptualizing, but the six degrees of separation between rising oil prices and a decline in the broad stock market are far more simple, direct and easy to understand. Yet the oil-fueled rally in the stock market since the mid-February low in the S&P 500 index (NYSEARCA:SPY) that is bolstering sentiment toward stocks is defying this relationship, at least for now. Therefore, I will explain how in six interconnected steps a continued rise in oil prices should translate into a decline for the broad stock market. It's a lot easier to conceptualize than how you might be connected to Vladimir Putin.

Oil prices (NYSEARCA:OIL) hit a new high for the year this week, up more than 13%, as speculators bet that Saudi Arabia and Russia will soon curb production. The US stock market, as well as foreign stock markets (NYSEARCA:CWI), continue to be highly correlated with the moves in oil prices, as can be seen below.

If this rise in oil prices was based on an increase in demand rather than speculation on a decline in supply, and if the rate of US and global growth was accelerating rather than declining, then a broad global equity market rally might be substantiated. The problem is that it is not. OPEC as recently as this week lowered its forecast for oil demand growth in 2016, and the Federal Reserve has unsurprisingly reduced the number of interest rate hikes it expects in 2016, as US economic data continues to disappoint. Given these circumstances, the first step to focus on is the impact rising oil prices will have on the rate of inflation.

1 - Inflation

The increase in energy prices, led by oil, will lead to an increase in the rate of inflation, as measured by the Consumer Price Index. In last month's Consumer Price Index report we learned that the rate of inflation fell from 1.4% to 1.0% in February on a year-over-year basis, but the index for all items less food and energy rose 2.3%, which was the largest annual increase since May 2012. In that report the cost of energy fell 12.5%, led by a more than 20% plunge in the price of gasoline, which was the category depressing the overall index.

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This morning we learned that the Consumer Price Index edged down from 1.0 % to 0.9% in March on a year-over-year basis, while the index for items less food and energy rose 2.2%. The cost of energy fell by 12.6%, again led by a more than 20% decline in the price of gas. I suspect these inflation numbers will be revised higher next month, since the report assumes that gas price only rose 2.2% in March when the national average price rose from approximately $1.75 to $2.04, according to the AAA's daily fuel gauge report. Regardless, it is clear that a continued rise in the price of energy will put further upward pressure on the overall Consumer Price Index. This leads us to the second step, which is wages.

2 - Wages

As a result of the increase in the rate of inflation, real average hourly earnings rose just 1.4% in March on a year-over-year basis. A 2.3% increase was reduced to 1.4% in real terms because the CPI index rose 0.9%. Real weekly earnings increased a meager 1.1% on a year-over-year basis, because the average work week shrank by 0.3% from what it was a year ago. I am focusing on real average hourly earnings, because this is the measurement of wage income that is most closely aligned with trends in consumer spending, and consumer spending accounts for more than two-thirds of US economic activity.

The rate of growth in real income has been declining even as the rate of inflation has declined over the past two years. In March 2015 real average hourly earnings were growing 2.2% on an annualized basis, and real weekly earnings, which take into consideration the length of the workweek, were growing 1.9%. Those figures have fallen dramatically one year later to just 1.4% and 1.1%, respectively. Therefore, an increase in the rate of inflation due to a continued rise in the price of energy, led by oil, is likely to further reduce real wages. This leads us to the third step, which is consumer spending.

3- Consumer Spending

It is real wage growth that fuels consumer spending. As real wage growth has slowed, the rate of consumer spending growth has been steadily weakening on a year-over-year basis, as can be seen below in the rate of retail sales growth, minus auto and gasoline purchases, for both high-end and low-end consumers.

What is relevant about this data is that low-end consumers were spending at a faster rate than high-end consumers over the past two years, as gasoline prices fell. This can be explained by the fact that low-end consumers spend more of their incomes on gas, so as gas prices declined, it allowed for more spending in other retail categories.

This is now changing, as the rate of growth in spending for low-end consumers has recently fallen back below the rate for high-end consumers, both of which are in downtrends. This is likely related to the rise in oil and gas prices that we are starting to see, as low-end consumers cut back on spending. A rise in energy prices, led by oil, that increases the rate of inflation and reduces real wage growth, will further slow the rate of growth in consumer spending. This leads us to the fourth step, which is US economic growth.

4- Economic Growth

Consumer spending accounts for approximately 70% of overall US economic growth. It dwarfs the impact that a modest recovery in the energy sector would have on the US economy. As the rate of consumer spending growth has slowed on a year-over-year basis, the rate of economic growth has also slowed from 2.9% to 2.7% to 2.1% to 2.0% over the four quarters of last year. According to the Atlanta Fed's GDPNow model, sequential growth is expected to be just 0.3% for the first quarter of this year. This will result in a fifth year-over-year quarterly decline in the rate of economic growth.

A continued increase in energy prices that leads to a higher rate of inflation and reduces real wage growth will further slow the rate of growth in consumer spending. This will also further reduce the rate of overall US economic growth. This leads us to the fifth step, which is corporate revenues and earnings.

5 - Corporate Revenues and Earnings

The primary reason why investors buy stocks is to benefit from the growth in a company's profits and associated cash flows. Profits, or earnings, are simply revenues minus expenses. Over the long term, there is a close correlation between the rate of economic growth and corporate profit growth. Companies in the S&P 500 index still generate a little more than half of their revenues from the US, which is a positive today considering that growth is non-existent in most other parts of the developed world. The International Monetary Fund continues to lower its forecast for global growth.

As the rate of economic growth in the US and abroad has slowed, we have seen the rate of S&P 500 corporate revenue and earnings growth decline. Revenues are expected to fall 1.2% on a year-over-year basis in the first quarter of 2016, which will mark the fifth consecutive quarter of declines. Earning are expected to fall 9.1% on a year-over-year basis in the first quarter, which will mark the fourth consecutive quarter of year-over-year declines.

While oil-exporting countries have obviously suffered as a result of the decline in energy prices over the past two years, there has been an offsetting positive impact on growth for oil-importing countries and consumer-based economies around the world, including the US. It seems that the anticipated boost to growth from lower energy prices has served only to lessen the decline in the overall rate of growth in the US and abroad. If energy prices continue to rise, the negative impact on growth could be far more pronounced.

A continued increase in energy prices that leads to a higher rate of inflation and reduces real wage growth in the US will further slow the rate of growth in consumer spending. Consumer spending is the predominant driver of economic growth in the US. A continued decline in the year-over-year rate of economic growth will further pressure S&P 500 corporate revenues and earnings. This leads us to the sixth and final step, which is stock prices.

6- Stock Prices

It is corporate profits that dictate stock prices over the long term. Stock prices can deviate from profits for extended periods of time, leading to valuations that are well above or below historical averages, but eventually prices revert to those averages. Currently, the forward 12-month price-to-earnings ratio for the S&P 500 index is 16.7, as can be seen below, which is well above the five-year average of 14.4 and the ten-year average of 14.2. Additionally, this forward price-to-earnings ratio is based on earnings estimates that assume a return to significant rates of growth in the second half of the year, which is very unlikely. This means that the forward multiple is probably much higher than 16.7.

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If energy prices continue to rise, it will clearly benefit the energy industry, contributing to overall US economic growth and lessening the decline in energy sector revenues and earnings. This will also lessen the rate of decline in overall S&P 500 revenues and earnings. Still, the headwinds to a rise in energy prices more than offset the tailwinds at this juncture.

Higher energy prices will increase the rate of inflation, which will reduce real wage growth. A decline in real wages will lead to a further slowing in the rate of growth in consumer spending. Slower rates of consumer spending growth will further slow the rate of US economic growth. A decline the rate of US economic growth will depress S&P 500 corporate revenues and earnings. If corporate revenues and earnings fall short of expectations for a recovery in the second half of this year, while valuations remain well above historical averages, then stock prices should decline to levels that fall back in line with, or below, those averages. These are the six degrees of separation between a rise in energy prices, led by oil, and a decline in the broad stock market, as represented by the S&P 500 index.

I recognize that there are an array of other factors that could affect these relationships. Some of these include whether or not the US dollar strengthens or weakens, the possibility that nominal wages increase at a faster rate than the rate of inflation and the potential that monetary or fiscal policy impacts the overall rate of economic growth. Yet the six interconnected actions and reactions that I have described seem to be the most likely to play out in the current environment should energy prices continue to rise.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.