Oil vs Dow: Does 2006 Rhyme with 1987?
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 outlined here and here. 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.
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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Hi - You people are really something! Oil prices jumped dramatically over the past six months and that was BAD for the economy (but great for the traders). Now, oil prices have returned to their 12/2005 levels and that is a worse calamity!!!! Why was the economy doing well with oil at $30, $40 or $50????
A few years back, oil prices were based on supply, demand and forecasts of degree days. Now, if a trader sees a wart on his big toe (or other appendage), he shouts to all of his trader friends that the sky is falling and that oil prices are too low. One lemming follows the other, regardless of reality and prices climb. Then they all compliment each other on how good they are at commodities trading!!!Experts like you say that this is GOOD, regardless of how it affects non-traders. Need I remind you that an oil minister was quoted several months ago as saying that “the world is oversupplied with oil”. You all remind me of nothing more than the thousands of poor Indian villagers who try to make $15-$30 per day by day trading. As one was quoted, “It is more than I could make at a real job”.
Thank you for your comments. If you read some of our previous posts on oil (http://stockmarketbeat.com/blog1/category/energy/) you will find that we are quite focused on supply and demand, if not degree days. (We don’t think we can predict them so for our purposes they amount to noise.)
I would think the post makes it clear our interest in the oil price is not day-trading. And we would never suggest that it is good for anyone to invest without a solid thesis on why there will be strong fundamentals.
As you correctly point out, whether oil prices are rising or falling will be good for some investments and bad for others. So naturally we think it is important to figure out which way oil is going (if we think we can.)
what does oil have to do with the dow
what does oil prices have to do with the dow
Both oil (as well as other commodities and stocks have tended to experience long-term cycles in valuation. In fact, they tend to follow the same cycle, only in opposite directions.
If you click on the article links that say “here” and “here” you will get to a more detailed description of why we think the current cycle (falling stock valuations and rising commodity valuations) is only about half-way completed.
Hope that helps.
Why does the price of oil affect the Dow Jones Average?
There are a couple of reasons oil prices tend to move in the opposite direction of stock prices.
First, since oil is an expense (directly or indirectly) for most companies, higher oil prices tend to reduce earnings.
Second, stocks don’t like inflation. Since oil/energy is a sizable component of inflation indices, oil prices affect inflation, which lowers stock prices.
Third, shocks to the economy tend to benefit oil prices but hurt stocks. For example, extreme weather can cause increased energy use (more heating and air conditioning) but affect consumer’s willingness to spend and can leave retailers stuck with the wrong merchandise. This will hurt earnings and the stock prices.
Hope that helps.