Oil Headwinds Become Tailwinds

Oil prices rising from $26 to $46 a barrel this year have helped boost US stocks a whopping 22% from their lows. The digital age led by Amazon and over capacity of retail space per capita may be killing retail bricks and mortar, but the dirty old energy driven industrial economy still holds some sway  over the economy and the stock market. While many factors move stocks, the headwinds or tailwinds from Oil are well correlated. Corporate earnings have been in a tailspin since early 2015 as enormous losses in the energy and raw material sectors weighed on the GDP and profits. Stock don’t need ever higher Oil prices, which would eventually be a negative, but they need stability and relief from the continual downside shocks that climaxed in January – February 2016. It’s no coincidence that our economy and stock market reached their current nadir during the first quarter in lock step with Oil prices. With metals and energy prices rebounding higher over the past 6 months, the anticipatory stock market has rallied sharply to new record highs on the expectation of  commodity price strength boosting overall earnings. No longer are Oil and commodity companies talking about increasing debt default rates, but instead they are increasing margins and improving financial stability. Thus positive year over year earnings comparisons from the raw material sector led by Oil will continue into the first or second quarter of 2017, assuming Oil averages above $40 and stays well away from its anxiety inducing bottom at $26 a barrel. A seasonal low in Oil prices late 2016 to early 2017 in the $30’s is likely, but should be a short term concern. With the awful energy related earnings component falling of annual comps over the next few quarters, we expect the “E” to begin to catch up to the “P” in the stock market Price to Earnings  valuation ratio.

Oil & Dow 8-16

When trader and investor sentiment become extremely optimistic it means that most of their excess cash has been used up and stock prices become more vulnerable to less than perfect news. Thus the concept of “contrary opinion” when excess optimism is bad and excess pessimism is good.  Option traders express their collective sentiment in buying Call option in  record amounts betting on higher prices. The current severe drop in stocks put to call ratios warn that while stock indices can go higher short term, the pressure of overhead resistance is building. Similar to the first half of 2015 we are again entering a zone where sharply higher stocks are less likely and the odds of a pause or correction are increasing. We still expect the Dow (DJIA) to exceed 19,100 eventually, but the 18,700’s may be a ceiling near term, depending upon Oil prices.option sentiment 8-16

Oil prices near $46 are fine for a slow growth economy without much inflation as it keeps investors positive the Fed is too afraid to raise interest rates. Strong job growth has been the sole factor encouraging the Fed to begin credit tightening, but subdued inflation and widespread economic data weakness continues to tie their hands and buoy investors. Certainly the marketplace would be shocked by any attempt to raise rates in 2016.  For now only 12% of those surveyed think our central bank will raise rates before the elections. We agree with the 88% crowd. This provides a solid floor for stock prices as long as the economic data avoids a sharper downturn. Oil will be a leading indicator of potential economic and earnings weakness.

rate hike chart

The SP 500 Index and Dow are almost 3% above their 2015 record peaks and we expect another 3% from here in the months ahead with continued appreciation into the spring of 2017. Over the short term, excessive trader optimism and the climax of the political season in September/October favor a more choppy market with modest corrections. With these short term headwinds it will require further sideways to higher Oil prices to sustain this rally in stocks.

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