Energy and Stocks decline together. The circular argument: which is leading which? – OptionsHouse (blog)

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Energy and Stocks decline together. The circular argument: which is leading which?

Spooky! That’s the general sentiment in the markets this week. It’s after Halloween, but it’s Friday the 13th and the markets are currently on course to close lower for multiple days in a row. Here’s a look at the S&P 500 for the last 10 days:

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Interestingly, it’s not just stocks that are selling off. We are seeing a concurrent move lower in energies as well. Take a look at oil over that last 10 days:

11132015-blog-oilfri

In fact, spooky might not even be the right name for it. The S&P 500 has turned negative on the year again:

11132015-blog-spx-2015

There are quite a few articles out there linking the slide in oil to the slide in the stock market. Market strategists keep pointing to the correlation being very tight between oil prices and the S&P 500. The question that gets asked: why is this?

The thought process can be very counterintuitive and even circular.

Some people see lower energy prices as a positive thing for the economy. Companies consume a lot of energy to create their products. They also consume a lot of energy to deliver those products to their customers. If energy prices drop, it turns into a windfall of savings for companies. Those savings translate directly to a company’s bottom line profits. So, when a significant underlying cost to a company to conduct its business operations suddenly becomes reduced, thereby saving the company a lot of money and making the company a lot more profitable, you would think that’s a good thing for the company. You would think that a more profitable company would make the company’s stock more attractive, and lead to the stock market going up.

To make this logic a little more tangible to an individual, think about what happens to your own monthly finances when the price of gasoline drops significantly. Instead of paying $52 at the pump each week to fill up your gas tank, you only have to pay $31. All of the sudden you find that you have an extra $100 of cash each month to spend elsewhere (or save, or invest!)

But this isn’t how it’s playing out in the markets. As oil has gone down, so has the stock market. Why is that? The real question to ask in trying to understand the relationship between oil and stock prices is: why is the price of oil dropping?

The market prices everything from a balance between supply and demand. If there is a glut of supply available, then there is probably going to be downward pressure on the price of that product as companies compete to sell their inventory. If supply is scarce, you would expect to see the opposite effect on price as buyers would push prices higher in an attempt to procure a product that is more difficult to purchase due to the fact that there is less of it available. On the demand side, if there are a lot of companies trying to purchase something, it tends to drive prices up as once again companies compete to procure the item that is high in demand.

However, what happens when demand drops? As the saying goes, this is where the rubber meets the road. This is where we see the link between dropping oil prices and the sympathetic drop in stock prices. There is a double whammy happening to the oil market. Not only is there a lot of supply available as new technologies have become available to extract oil from the earth, but also there has been a drop in demand to buy oil. Why is demand dropping, because companies are consuming less energy to produce and deliver fewer of their goods. Why are companies consuming less energy, because there is less demand for their products. And if there is less demand for a company’s products, investors see less of an opportunity and less of an upside in investing in that company’s stock. When there are fewer buyers of stock, it translates to the stock price going lower.

With stocks prices lower, and companies seeing less demand for their products, they consume less energy. This drives energy prices lower. Investors see soft oil prices as a leading indicator of softness in the global economy leading investors to sell stocks. This drives stock prices even lower, which puts more downward pressure on the price oil, which again puts more downward pressure on stocks! And around, and around, and around the argument goes.

If you’re not buying into the argument of weak demand for products drives weak demand for energy pushing both stock prices and energy prices lower, look no further than what is currently happening in the retail space. We have seen earnings and forecasts for very large retailers get hammered this week. Walmart, Macy’s, Nordstrom and J.C. Penney and all perfect examples of this.

The Federal Reserve is painting a different story about the health of the economy, which is a way for the Fed to reverse its course on the quantitative easing policy and start raising interest rates again. The retail sector, energy prices and overall stock market are perhaps conveying a slightly different message. It will certainly be interesting to see how things pan out through the end of the year. Hopefully, though, this article helps you get a little understanding of how different asset classes can impact each other’s pricing.

The above information is provided by OM Securities, LLC dba OptionsHouse (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.