Oil vs. Dow: 1987 Deja Vu All Over Again?

Includes: DVY, SPY, USO
by: William Trent, CFA

Oil prices have fallen as much as $16 from their peaks, their steepest reversal in 16 years, in a correction that traders say may be harder to shake off than past setbacks in the market’s four-year rally.

In percentage terms there have been bigger stumbles on oil’s recent ascent, propelled steadily higher since 2002 by the war in Iraq, soaring Chinese demand, constrained oilfield and refinery production, devastating US Gulf Coast hurricanes, and most recently fears of a disruption to Iran’s exports.

But some say this latest setback — triggered by easing concerns on Iran, a weak storm season and a refocusing on healthy consumer nation inventories — may prove more lasting.

“Even though we’ve retraced certain percentages similar to this, it definitely seems that the market is different now,” says New York-based ABN AMRO broker John Brady. “Other times I saw (the corrections) leading to great buy opportunities, but I don’t necessarily think that this time.”

While our bullish stance on oil was essentially inline with consensus views two months ago, the consensus is now rapidly shifting away. Still, we believe this is part of a multi-year reversal of fortunes for stocks and commodities that is perhaps halfway through, for reasons we have previously outlined. For perspective, we consider the last time there was such a reversal - 1982.

We gathered monthly closing prices for the Dow Jones Industrial Average from Yahoo! Finance, and for spot oil prices from the St. Louis Fed. Then, we picked approximate dates for the two reversals - January of 1982 and January of 2000. There are probably more exact dates to choose, but we decided to go with the beginnings of years so as not to be accused of massaging the data. The general trends are what interest us, and they are apparent. Oil’s recent run looks very much like the 1980’s Dow, while the Dow’s recent plodding looks like oil used to. We’d definitely call that a reversal.

oil vs dow

The chart also tells us that oil was getting due for a crash along the lines of the 1987 stock market crash. A similar setback from the recent highs suggests a mid-50’s oil price. If history is a guide, investors will look back on that time as an ideal buying opportunity.

So what about the sudden bearishness on the part of followers such as ABN’s Brady? We can again point to similarities with the 1987 crash, as discussed recently in a Fortune column called The Legend of Robin Hood.

The idea behind one of the most innovative and influential philanthropic organizations of our time sprang from one of the more boneheaded macroeconomic calls ever made on Wall Street. Or as hedge fund maestro Paul Tudor Jones tells it, “The biggest error I’ve ever made had the best possible outcome.”

The story begins in the summer of 1987. Stock prices were soaring, but so, too, were interest rates. The then 32-year-old Jones - who had made buckets of money during the go-go 1980s - was getting nervous. That September he told his investors that the stock market reminded him of 1929 and a crash was inevitable.

Even after October’s brutal 23% one-day drop, Jones remained apocalyptic. He called up fellow hedge fund manager Glenn Dubin and pleaded, “It’s happening. We’re going into a great depression. We’ve got to do something about it. I want to start a foundation to help, and I’d like you to be involved.”

If we’re right about the historical pattern rhyming, we wish Brady all the success Tudor Jones has seen, and hope his fears are put to as productive a use.

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