Tuesday, July 8, 2008

Revisiting the Relationship Between Oil and Stocks

Oil prices have dropped almost $10 since peaking at $146 a barrel last week. The stock market responded favorably today as stocks staged an impressive late day rally.

The conventional wisdom says that falling oil prices stimulate demand and ease margin pressures on companies' earnings so any decline in oil prices is bullish for stocks. But even as he predicts a relief rally, Kevin Depew, executive editor of Minyanville.com is skeptical about the conventional wisdom governing the relationship between oil and stocks. According to Depew, falling oil prices are a barometer of weakening demand and a softening global economy. Depew also believes that spells bad news for earnings - and the energy-heavy S&P 500 index that includes Exxon, Chevron and Apache to name a few. You can watch all of Depew's interviews, including the one on Fannie Mae and Freddie Mac on Tech Ticker by clicking here.

I disagree with Depew that speculation is not driving oil prices higher but I totally agree with him that falling oil and commodity prices are a reflection of slowing global growth - and that is not good for stocks. If a relief rally does develop, investors need to stay alert and see it as an opportunity to reduce their exposure to financial stocks. Importantly, this is not a new bull market but a relief rally based on technical indicators that suggest certain sectors are way oversold (click on image above).

Finally, I added Hoisington Investment Management Company in my market research links. I quote the following from their Quarterly Review and Outlook, Second Quarter 2008:

"Our conclusion is that deflation, not inflation, is, and will continue to be, the essential problem for the U.S. economy and that the optimum fixed income portfolio should consist of treasuries with the longest possible maturities."

I highly recommend you take the time to read the Hoisington quarterly review. My view has not changed. Going forward, the driving force behind the economy will be asset price deflation, not commodity price inflation. I still believe that the worst is ahead of us, especially in 2009. We will probably see many "relief rallies" in the stock market but the big picture trend will remain down. Beware of Wall Street cheerleaders jumping on every relief rally to proclaim the worst is behind us. As long as house prices keep declining in the U.S. and elsewhere, we are not out of the woods. This "relief rally" looks like another bear trap.

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