Week Ahead: Can Oil Lead Stocks Higher?

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The relationships between different financial markets are never straightforward. If it were as simple as “If A happens, B and C will surely follow” we would all be traders, and fabulously wealthy ones at that. There are some general guidelines that should be borne in mind, but even those change over time.

For example, it used to be that Treasury yields and stocks moved in the same direction, but for a long time after 2009, yields dropped in response to the Fed’s actions, even as the stock market climbed. Similarly, there was a time when rising oil prices meant falling stocks and vice versa, but that also no longer applies.

If anything, stocks and oil have shown a tendency in recent years to move in unison, so, as oil appears to have found a low, can we expect stocks to rebound with it?

To answer that question, you have to understand what has changed about the old oil/stocks relationship.

It is actually quite simple. Oil production in the U.S. has increased to the point where the negative effects on the American economy of higher energy prices are more than offset by the positive effects of greater profits in the oil business. With the U.S. no longer a massive importer of crude oil, and even becoming a net exporter of crude for the first time in November of last year (albeit for only one month’s report) high oil prices are no longer a danger.

Source EIA.govSource EIA.gov

That fundamental change in the relationship between the two markets is not what caused them to move in the same direction in the last quarter of 2018, but it did allow it to happen. Traders in both markets were reacting to the possibility of slower growth, both globally and here in the U.S., while oil had the added problem of increased supply.

Without the offsetting effects of high U.S. imports, the dramatic drop in crude, rather than being seen as reducing costs for businesses and helping stocks, added to the concerns of equity traders and investors and accelerated the collapse.

Oil FuturesOil Futures

S&P 500S&P 500

As you can see from the charts above, both markets bottomed out at the same time, reaching their lows on December 26. That further reinforces the belief that they are responding to the same things, but, as already mentioned, oil’s decline had an additional, supply related element to it. Concerns in that direction have eased recently with the news that Saudi Arabian exports of crude dropped significantly in December, suggesting that traders’ doubts about the will of OPEC’s de facto leader to really reduce output are unfounded.

It may seem at first glance that decisions made in Saudi Arabia about oil output levels would have no effect on U.S. stocks whatsoever. That certainly sounds logical, but in a still volatile market, logic is not the point.

What matters in nervous markets is emotion, and the sight of oil moving higher, even if it is being propelled in part by matters completely unrelated to stocks prices here in the U.S., will be reassuring for traders and investors.

At a time when crude oil and stocks have shifted their relationship from inverse to direct correlation, an outside stimulus to either market can help the other. The more optimistic view of oil based on reduced supply, therefore, could be what the stock market needs to settle its nerves this week and allow for a sustained recovery.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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