Is It Time to Fear Oil? Not Until These Three Conditions Are Met
Fortunately, not one of the three is happening right now.
I never worry about action, but only inaction.
Yesterday I participated in an interactive webcast hosted by Minyanville exclusively for Buzz & Banter subscribers, and a lot of really great topics were brought up. One participant wanted me to address the impact of oil on markets given fears over an impending military conflict in the Middle East and the potential spike in energy prices that could cause.
As to oil more generally, gradually rising oil is correlated with rising stocks. Why? Because gradually rising oil increases cost-push inflation, which in turn causes inflation expectations to rise. This is a favorable environment for risk assets as I have generally discussed for some time in my writings. When oil spikes, however, expectations for deflation kick in because the speed of the move makes it impossible for companies to react quickly enough.
As to when to fear oil, I noted that three conditions must be met before prices would be affected (the "Oil Spike Trifecta").
First, oil itself (USO) would have to begin to substantially outperform stocks (IVV). Second, energy stocks themselves (XLE) would have to underperform broader stock market averages, because a spike in oil prices would be damaging to longer-term planning. Third, the stocks of military contract providers would have to begin to dramatically rally as money bets on impending conflict.
Not happening as of right now. Take a look below at the price ratio of the PowerShares Aerospace & Defense (PPA) portfolio relative to the S&P 500 (IVV). As a reminder, a rising price ratio means the numerator/PPA is outperforming (up more/down less) the denominator/IVV. A falling ratio means the opposite.
Notice that despite war talk, the performance of defensive stocks on average has been anything but strong. The ratio continues to point lower, as money, in reality, bets that conflict will be avoided. That, combined with oil itself not performing that well, suggests we don't have to be too concerned in the near-term for now based on the way money is betting.
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