80-20 Investor  

Oil Leak

In recent notes I’ve looked at what has been driving the market up, in the US that’s principally been tech stocks. This week equity markets stumbled after an initial bounce on Monday. At the time of writing the FTSE 100 is down around 1.5% with this pattern repeated across the main equity indices in the US and Europe.

Interestingly the Nasdaq 100, the key US tech index I talked about last week, is up 1.7%  So if technology stocks are having a respite from their recent angst what is it that has been driving the market downwards?  At the start of May I speculated on where the next market shock could come from. At the time I wrote:

"While we can’t ever predict what might derail the stock market don't be surprised if we start hearing more about the price of oil. The price of oil has fallen sharply this week and hit a five month low of around $45 a barrel before rebounding. This is way below the crucial $50 a barrel mark. At one point the oil price was down 15% from its price at the start of the year due to a supply glut. This is despite OPEC’s agreed production cut in November. Interestingly there have been signs of an increasing correlation between equity markets and the price of oil once again. If that correlation strengthens then the direction of the oil price could be a factor in whether we see new stock market highs or a retreat."

You can see from the chart below (which shows the price of oil year to date) that we are now experiencing the latter scenario with the oil price slump pulling energy stocks lower, dragging the wider equity indices with them.

The reason behind the latest oil price slump is that investors are losing faith that OPEC (the Organisation of the Petroleum Exporting Countries) can deliver on its promised oil supply cuts. OPEC is the cartel of key oil producing nations which try and ‘fix’ the price of oil by controlling the supply of the oil they produce. In 'economics 101' you’d learn that supply and demand dictate the price of an asset and in a world where Libya and Nigeria are ignoring the cartel and the US shale industry continues drilling there’s an oil supply glut. Therefore, because supply outstrips demand, the price of oil falls. 

For armchair investors they may see this manifest itself in their portfolio when energy and oil stocks (which are sensitive to the price of oil) also tumble. They make up a significant proportion of many equity indices, especially the FTSE 100. But if the supply of oil outstrips demand it also leaves markets wondering why demand is so weak. The logic at that point is that oversupply suggests that global growth is slowing as there is less demand for commodities to build stuff. As oil prices fall inflation should also dip. Low growth tends to mean lower company profits in cyclical industries (those most exposed to the economy). So investors either sell out of the market altogether or rotate into less economically sensitive industries such as technology. In a wonderfully circular way it helps explain why technology stocks performed so well this week.

Drug companies also perform well in low growth environments, after all we still need drugs even in a recession. It follows that biotechnology firms in particular had a good week, especially after news broke that the US healthcare reforms might not attack drug companies and their pricing after all. In addition when economic growth is weak bonds perform well. 

When will the oil sell-off stop?

That depends on OPEC’s ability to act in unison but also on the US shale industry's inclination to keep drilling. Some analysts are predicting the oil market to fall as much as 20% from where we are now. The question really should be 'how strong is the correlation between equities and oil?'.

The truth is that while the correlation between oil and equities is positive they don’t move in lockstep. The correlation between the S&P 500 and the FTSE 100 and the price of oil is almost exactly 0.6. Remember correlation is measured between a range of -1 and 1. A score of 1 is a perfect correlation, a score of 0 means no correlation while a score of -1 represents a perfect negative correlation.

You can see that while the correlation is positive it remains fairly week. In addition it’s unusual for the correlation between oil and equities to last. In 2016, for example, the correlation moved to 0.6 before moving down into negative territory. If history is a guide the same will happen again, we just don’t know when. Over the long-term the price of oil and stocks tend to move independently, only following or mirroring each other occasionally. In truth the oil story has provided a justification for investment banks to rotate in to other sectors that have lagged in the recent rally (such as biotechs). 

A year on from the Brexit vote and the value of the pound is continuing to have the most significant impact on UK investors, not the price of oil. The correlation between the strength of the pound vs the dollar and the FTSE 100 is - 0.9.  So when the pound falls the FTSE 100 tends to rally. Yet as I’ve pointed out, even this correlation is prone to breaking, as they all do.

New Research

I'm currently putting the finishing touches to a new research article which you will receive early next week. In the meantime if you have any ideas that you'd like to see form the basis of my next piece then please let me know by replying to this email.

Data Update

As ever I have updated the Best Funds by Sector tables.

Best Wishes
Damien Fahy
80-20 Investor & founder

Damien is regularly quoted in the national press including:
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