Oil has fallen approximately 20% over the past month. Here’s the chart.
For some investors, oil’s recent decline has brought back memories of 2015 and 2016 when oil’s decline led to a significant correction in the U.S. stock market. CNBC said “oil has entered into a bear market!” (CNBC defined a “bear market” as a 20% decline from 52 week highs).
Statements like these make flashy headlines but are useless to investors.
Since 1980, oil has been in a “bear market” (as defined by CNBC) approximately 33% of the time. CNBC’s headline is a meaningless statement.
We only care about oil to the extent that it impacts the S&P 500. We don’t trade oil.
From a quantitative perspective, our model does not see a significant correction or bear market for the S&P 500 in the foreseeable future (i.e. 1 year forward).
From a discretionary standpoint, oil’s recent decline will not cause a significant correction in the S&P.
There are only 3 ways in which oil’s decline can cause a significant correction in the S&P.
- Oil’s crash causes the energy sector to crash. Energy is 1 of the S&P’s 11 sectors.
- Oil’s decline hurts the U.S. economy enough to cause a significant correction in the U.S. stock market.
- Oil’s decline spooks investors and causes “contagion”. (Similar to the 2015-2016 oil crash).
None of these methods are valid today.
An energy sector crash cannot cause a significant correction or bear market in the S&P
For starters, the energy sector has fallen more than oil since early-2017. So purely from a mean-reversion perspective, the energy sector cannot fall much more. Yes, the energy sector might make 1 more spike down, but don’t expect it to fall another 20-25%. Here’s XLE (energy ETF).
Get my book!
From a long term valuation perspective, the energy sector’s valuation is very low. Valuation cannot be used as a short term indicator. However, it’s a sign that the energy sector cannot crash again the way it did in 2014-2016.
Let’s assume that we’re wrong. Let’s assume that the energy sector crashes and goes to $0. (This is a completely ridiculous assumption.)
The energy sector accounts for only 6% of the S&P 500. So if the energy sector falls to $0, the S&P will only fall 6%. That’s only a “small correction” for the S&P.
Oil’s decline will have a negligible impact on the U.S. economy
Oil’s recent decline is supply-driven and not demand-driven. There has been no noticeable drop in demand for oil. U.S. consumption and manufacturing are still growing at a decent pace. Oil’s decline is caused by soaring non-OPEC supply. The U.S. is pumping oil like never before thanks to falling shale production costs. Meanwhile, Libya and Nigeria are bringing their oil production back online.
The medium-long term trajectory for the U.S. stock market is determined by the state of the U.S. economy. The overall trend in U.S. economic data points to continued growth.
Oil crashes don’t cause significant corrections or bear markets in the U.S. stock market because the U.S. is not an oil-driven economy. The U.S. is not Saudi Arabia. Yes, some areas of the U.S. will suffer when oil crashes (i.e. oil producing states). But other areas of the U.S. will benefit because oil is a cost to consumers and a cost to many businesses. Overall, the negative effects from falling oil prices and positive effects from falling oil prices offset each other.
The difference between today and 2015/2016
Oil has fallen 25% since the beginning of 2017.
By comparison, oil CRASHED 60% from June 2014 to March 2015, 3 months before the S&P began a significant correction. So unless oil crashes from $55 to $25 today, comparing the present case to 2015/2016 does not make any sense.
Oil crashes don’t always cause significant corrections in the S&P
The third fear is that a crash in oil will lead to “contagion” and hurt the U.S. stock market. History shows that this isn’t a valid argument.
A lot of historical oil crashes didn’t lead to significant corrections or bear markets for the S&P 500. This is why we don’t use correlation in our S&P 500 model. Sometimes correlation works and sometimes correlation doesn’t work. Here are some historical examples. We’re looking at cases in which oil fell more than 40% within 1 year.
July 11, 2008 to December 19, 2008
Oil crashed 77% during this bear market. However, oil’s crash did not lead to the S&P’s bear market. The S&P’s bear market from October 2007 – March 2009 caused oil’s crash. The stock market topped far earlier than oil.
Here’s the S&P.
December 1996 to December 1997
Oil fell 40%. The S&P rallied strongly during this time. The S&P’s next significant correction began in July 1998. The S&P’s significant correction was not caused by oil’s crash. Our model’s indicator that predicted the 1998 correction has not occurred today. In addition, the 1998 crash coincided with (but was not caused by):
- A massive downturn in the Japanese economy
- The Russian financial crisis
There is no major crisis situation in the world today.
Here is the S&P from December 1996 – December 1998.
September 1990 – February 1991
Oil spiked when the S&P made a significant correction from July to September 1990. Oil crashed after the S&P’s significant correction bottomed.
Here’s the S&P.
November 1985 – March 1986
Oil cratered more than 66% during this period. The S&P soared. The S&P’s next significant correction began in August 1987, 1.5 years after oil’s crash hit bottom.
Can oil’s decline lead to a small S&P correction?
Yes! That is a possibility, and we’d set the odds at 30-40%.
If the S&P makes a 6%+ “small correction”, we’ll shift from 100% cash to 100% long UPRO (3x S&P 500 ETF).