Oil and Stocks Don’t Mix

One of our favorite investment games is called “What if I told you…” Some examples:

• What if I told you the Republican Party will hold on to the House and Senate during the midterm elections… Would that matter to your perspective on US equity valuations for the remainder of 2018?

• What if I told you the US will have a brief shooting war with North Korea this summer, but it would end with no US casualties and the regime there abandoning its nuclear ambitions? How would that reshape global politics, and how much would capital markets shift through that news cycle?

• What if I told you crude oil prices will end 2018 at $93/barrel? Would stocks be higher or lower?

That last one may seem the simplest of the three – rising oil prices should be a notable sign that the global economy is recovering at an accelerating rate and stock prices will rise. And Energy stocks are 6% of the S&P 500, of course, which might help push equities higher.

But then… maybe the current market fixation on inflation would take higher oil prices as yet another sign that interest rates must move higher as well.That would ding US equity markets further… So maybe $93/barrel is bad for stocks?

The simple truth is that the direction of oil prices tells us nothing about where US equities will go. We pulled the prices for the S&P 500 (from Yahoo Finance) and the average of West Texas Intermediate, Dubai, and Brent crude oil (from the World Bank) back to 1990 and looked at monthly returns. At first blush, the relationship looks good. Average monthly price changes are similar (+0.7%) even if oil prices are about twice as volatile as US large cap equities.

When you look at the statistical relationship between the two, however, you see there is really no historical connection. A few points here:

• The oil/stock price change data from 1990 to the present shows a 0% r-squared between crude and US stocks. Oil prices will do whatever they will do, and stocks follow their own path.

• Zoom in to 2005 to the present, essentially the last 2 economic cycles, and the r-squared is 10.2%. Better than zero, but hardly enough to base a robust relationship. For what its worth, the slope of the regression line is modestly positive over this period. Higher oil prices do slightly correlate with higher stock prices.

The upshot is straightforward: don’t worry too much that faltering oil prices are a sign of a broader problem with US equities. Oil may end the year at $93 or $43, and history says it won’t matter much to the direction of domestic stocks.