Why are stock prices moving up and down with oil prices? - J.P. Morgan Asset Management

Why are stock prices moving up and down with oil prices?

Contributor Dr. David Kelly

While it is logical for energy company stocks to move up and down with oil prices, we believe the high correlation of stock prices with the overall equity market has been caused, in part, by markets misinterpreting oil price weakness as a sign of more general trouble in the global economy.

The positive correlation between oil prices and stock prices in recent years can be seen in the chart below. At first glance, it is puzzling since, for many years, the U.S. has been a heavy net importer of oil. As a result, lower global oil prices should have been a positive for the U.S. economy with the consumer benefit from falling oil prices outweighing the pain inflicted on producers. Indeed, it is worth noting that a spike in oil prices immediately preceded four out of the last six U.S. recessions. It does have to be acknowledged, however, that energy companies account for a much bigger share of the stock market than oil production represents as part of our GDP. So while lower oil prices have been overwhelmingly a positive for the economy, this has always been a closer call for the stock market.

The ambiguity of the implications of lower oil prices for the stock market has increased in recent years as the growth of the U.S. shale-oil industry has closed the gap between U.S. production and consumption. As recently as 10 years ago, the U.S. imported 60% of its oil consumption. In 2015, net oil imports amounted to just 22% of consumption. 1

However, even given the growth in the U.S. oil industry, the very high positive correlation between oil prices and U.S. stock prices in recent years seems hard to rationalize. However, there are two other factors that may help explain it.

First, there is a significant negative correlation between the dollar and oil prices – when the dollar goes up, oil prices tend to go down and vice versa. However, a high dollar on its own is a negative for U.S. stocks – first because it reduces the dollar value of foreign profits and second because it makes it more difficult for U.S. companies to sell abroad. To some extent, the positive correlation between oil prices and the stock market may be a spurious correlation due to the relationship that each of these economic variables has to the U.S. dollar.

Second, since 2009 when oil prices plunged in the midst of a global recession, many investors have seen oil as a barometer of the state of demand in the global economy. While this can sometimes be the case, the reality in 2016 is that global oil consumption is growing at a fairly normal pace – about 1.3% annually between 2013 and 2016. The reason oil prices are low globally is because of a surge in production both from U.S. shale oil producers and OPEC, which has ballooned global inventories.

Investment Implications

Even without OPEC restraint, oil prices should slowly recover as low oil prices have caused energy investment spending to collapse globally. However, until then equity investors should not read too much into the price of oil but rather focus on the broader economic fundamentals determining earnings growth and interest rates.

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