Why is oil driving the stock market?
Why should world equities trade off the oil market? There’s no doubt that oil led the stock market down over the past several months, and that the whipsaw in the oil price took equities along with it. We can see as much from the price graph of 5-minute interval observations for oil and S&P futures. Statistical analysis confirms what we see in the chart. Stocks can’t win for losing. As long as oil trades badly the equity markets will remain vulnerable. The relationship is also evident in the risk market: the cost of options on oil (measured by implied volatility) has jumped while equity market options have been relatively stable.
Risk markets are more correlated than at any time since the 2008 crisis, when everything blew up together. That’s the fault of central banks, who tried to force investors into risk by reducing interest rates to near zero, and in some cases below zero. The moment that the Fed talked about “normalizing” US interest rates, asset prices fell back to their own “normal levels.”
But the relationship between oil and stocks requires a bit more explaining, because the oil sector as such hasn’t been a major factor in overall equity market returns. During the past six months, bank stocks had the biggest impact on overall market returns. The S&P 500 lost 54 points in the past six months, and the 10 worst performers account for 37 of those points. Apple contributed -7 points, followed by the four top US banks, who accounted for -17 points. Two infrastructure partnerships and pharmaceuticals companies also made the bottom ten.
|Total Index Points||-54|
|Bank of America||-5|
|Total for Worst 10||-37|
In 2014, by my calculations, 40% of total S&P 500 capital expenditures went to the energy sector. The shale boom was the biggest thing going, and banks as well as high yield bond funds poured money down the wells. With oil around $30 shale loses money, and banks are reporting multi-billion dollar losses. The high-yield energy sector as a whole now yields 15 percentage points more than US Treasuries, which means dollar prices in the 70s and 80s. Depending on what lenders think they can recover from busted shale borrowers, high-yield market prices imply an expected default rate of 20%-25%. It gives a whole new meaning to the term “horizontal driller.”
Nothing is going right for the banks. The money management industry is so concentrated in a few giant hands, e.g. Blackrock and Pimco, that securities dealers can’t earn a living trading for (or against) their customers. The yield curve is so flat that they can’t make money borrowing short and lending a little bit longer. And their lending portfolios are getting high.
That doesn’t add up to a banking crisis — not by a long shot — but it does mean that credit conditions will remain nastily tight for the foreseeable future. That’s bad for every economic sector.
US data continue weak. The Markit services PMI printed at 49.8 for February, falling below the 50% neutral level for the first time since October 2013 from a January level of 53.2. gain in nondefense capital goods orders ex-aircraft probably is a quirk of seasonal adjustment. Year-on-year, capital goods orders remain extremely weak.