The Meme Of Oil/Stock Correlation Doesn't Make A Lick Of Sense

Includes: DIA, IWM, OIL, QQQ, SPY, USO
by: Jim Sloan


There's a market meme of the last month or two that the stock market is correlated causally to the oil market; oil up, stocks up.

Oil would be up for one of four reasons: oversupply, too little demand, a combination of the two, or speculation had driven it far too high.

One argument is that a higher oil price either reflects better global growth prospects or saves financial and employment fallout from lower oil prices.

The verb tenses don't work. We would see global growth first from other indicators. The argument is ex post facto, and illogical.

Can you imagine economic happiness from the OPEC cartel getting prices up? It's a thing we prayed to not have in the 1970s.

Doha has nothing to do with it. Stocks didn't rally in spite of it. They rallied for their own reasons, or for no observable reason at all. More buyers than sellers, a wise friend used to say.

My favorite philosopher, David Hume, spent a lifetime instructing thoughtful human beings to be wary of attributing causation to anything. He was adamant that a good bit of what is thought of as causal is actually random association. Hume was especially hard on miracles. Which brings us to oil prices and stock prices.

The recent market meme has it that higher oil prices are helpful to stocks. The argument doesn't make a lick of sense. If there is any causal correlation between the price of oil and the price of stocks at this particular moment it would indeed be a miracle - miracles being defined as violations of common sense, logic, and natural law.

Here's the logic of oil prices and stock prices. It starts with working out the likely causes of lower oil prices. Here they are:

(1) Oil had a supply problem. There's too much of it produced at the higher prices. Too much oil could be profitably pulled out of the ground at prices of, say, 70 to 120. The slope of the decline may have been eased by producers who had to sell at any price, both oil-producing countries and leveraged producers (the domestic frackers) who had to produce in the attempt to stay above water as long as revenue exceeded incremental costs. The apparent bottom may represent their capitulation, of one kind or another.

(2) Oil had a demand problem. The world economy, especially China, was slowing, and the demand for oil was falling. When oil rallies, the global economy is looking better.

(3) Oil prices reflect a combination of the supply problem and the demand problem.

(4) The oil price at the top was too high by a mile. Speculation drove it up, the last speculator bought, and it started to fall. Once it fell, the speculators got in line and sold heavily. The bounces and retests, etc., are speculative. This interpretation may fold in some elements of all the others.

What do I think? You shouldn't care. For what it's worth, I think it's a combination of reasons (3) and (4), with highest emphasis on the supply problem, and secondarily, especially the volatility, on speculative actions.

What is buried in any of these possible reasons to suggest that a Saudi-led deal to reduce supply was good for the U.S. stock market? The snap answer, prominent in the headline meme, is that rising oil is evidence of a better global economy. But what on earth would that have to do with Saudis and the rest of OPEC managing to get the price up? The argument is entirely ex post facto.

It's all in the verb tenses.

If oil rose in price because of stronger demand, it would be reflected in the price already and need no help from OPEC. Oil price is not a leading economic indicator. The Baltic dry rate might be. Electricity use might pull some economic truth out of China. The oil price going up would be late in the game for buying global equities. It's ex post.

A weaker rationalization is that it is a matter of overleveraged oil producers being saved and a financial meltdown avoided. Forget that. U.S. Bank just took a one quarter write-up of reserves. Wells Fargo ditto. That's not the financial system on the brink of anything. The only rational sliver in this argument is that it might account for rallies in highly leveraged producers - not a real market mover.

Oil has the potential for a single major impact on global markets. In the inverse condition from today, with a powerful squeeze resulting from political withdrawal of oil, markets do have major problems. This happened in 1973 and 1979 under conditions very different from the present.

The last thing anybody wanted to hear in those days was that OPEC ministers were getting together to get the price up. The Saudis were counted on to restrain the others, or overwhelm them with production, partly because they were U.S. "allies" but mainly because they didn't want to kill the global oil-consuming economy.

The decline in oil prices, as a few of the more logical analysts have pointed out, should with a little lag time add to consumption. It might shift market rotation toward consumer discretionaries. Because consumption is weak, and has multiplier effects, it might - might - exceed the loss of jobs and income from workers involved in oil production. There are lag times to weigh. I suspect the net effect is small. It seems to have been so far. I doubt that this factor greatly affects the overall market.

What if Doha had worked out. Attention, folks, the Saudis assembled the rest of OPEC and got the oil price up! It's great news, folks! Not.

The nonsense about higher oil prices doesn't even produce a tradable or investable play. It's silly. It doesn't make a lick of sense.

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.