One Chart and Two Numbers to Help Us Understand Oil's Impact on Stocks By Dr. Van Tharp Trading Education Institute
It's hard for traders and investors to keep their eyes off of oil prices. Indeed, the correlation between oil and stocks has been much discussed, and active traders know that stocks have followed oil price action for some time now.
With all this talk about the correlation between these two traditionally mildly correlated assets, is there any real proof that their correlation has, in fact, increased? Let's go to the charts to find out! Below, you'll see a chart that shows the price of crude oil on the top chart, the S&P 500 price in the middle chart, and the correlation coefficient of the two in the bottom chart:
First, here's a quick correlation refresher. If the correlation coefficient is 1.0, the two instruments are perfectly correlated (move in the same direction all the time). A correlation coefficient of 0 means they have no correlation and a -1.0 figure means they are inversely correlated or move in opposite directions.
The chart above definitely shows that the correlation between the price of oil and the S&P 500 has grown substantially since last summer. In fact, from July of 2014 until August of 2015, stocks and oil had practically no correlation. Since then, we can clearly see that the movements of the two assets are much more closely related.
And if the way oil prices are leading stocks these days is not enough to catch our attention, let's look at two numbers that may show us why this is happening.
Two Numbers that Show the Big Effect Energy Stock Earnings Have on the Broader Market
We've already seen year-over-year (YoY) declines in earnings for the second and third quarters of 2015. Fourth quarter earnings seem to show more of the same. With 63% of companies reporting through Friday (2/5/16), earnings report stalwart Factset shows a near certainty that we'll get another YoY decline for the fourth quarter of 2016. This will mark the first time of three straight quarterly declines since the first three quarters of 2009.
Factset provides an earnings number they call blended results. This number allows full-quarter equivalents to be tracked throughout the reporting period. It combines the actual results so far with analysts' projections for companies that have not yet reported. For 4Q, 2015, Factset's blended result is a decline of -3.8%. That's a pretty big negative number.
But here's the real kicker: when we exclude the Energy sector, the blended earnings decline for the S&P 500 disappears - all non-energy sector stocks show a positive 2.2% YoY gain. That's a huge change from an overall -3.8% number!
I would propose that pundits looking for reasons why stock index prices have tracked so closely with oil prices over the past few months - look no further than the impact dropping oil prices are having on energy sector earnings! Then we can see how tough it is to have a positive earnings quarter when the energy sector is getting slammed. So when oil prices slide, the stock market sees it immediately as bad news, and vice versa.
Morgan Stanley and the International Energy Agency both put out sustained low-price forecasts for the first half of 2016 (Morgan Stanley actually lowered their first half target price 50%!). With those types of projections, it's easy to envision many more months where the price of stocks is closely tied to the price of crude.