Oil, the Economy, and the Stock Market

The Oil Factor: Protect Yourself-and Profit-from The Coming Energy Crisis
by Stephen Leeb, PhD., Donna Leeb

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During the years between 1973 and the turn of the century, while oil prices bounced up and down between a low of around $10 a barrel and a high of near $40, we experienced five recessions and several periods of strong economic growth. Meanwhile, as far as stocks went, we've had bear markets, in which stocks dropped nearly 50 percent, and some prolonged and glorious bull markets. Who says life is dull?

The point is that if you looked at when the economy went into a tailspin and when stocks tanked, you'd see that these periods were always preceded by rising oil prices. By the same token, falling oil prices preceded economic good times and strong financial markets. It's like those acetate overlays in books depicting the human body, in which a sheet depicting branching blood vessels lies neatly over a sheet showing the skeletal frame. If we had such overlays, we could fit economic and market trends snugly within changes in oil prices.

Let's briefly look back at the economy and market during those same thirty years since 1973 and see just how their ups and downs intersected with trends in oil. It is no coincidence that the period 1973-82-which saw oil prices rise from below $5 a barrel to nearly $40 a barrel-was one of the most turbulent in U.S. economic history. Inflation soared into double digits, and the economy experienced three recessions. Moreover, during those years, economic dogma was rewritten. Until then there was a well-established relationship between economic growth and inflation. When growth was strong, inflation would pick up; when growth was reined in-by rises in interest rates and a tighter money supply-inflation would fall.

This relationship, which had long been a reliable road map for economic policy, was blasted out of the water by events in the 1970s. Because of our lack of control over oil, inflation and recession were no longer mutually exclusive. As OPEC engineered rises in oil prices, prices rose across the board, even in the face of a slowing economy.

In the 1970s, a new term entered the economic lexicon: "stagflation," a combination of stagnant growth and high inflation. At times we didn't know which of these enemies to fight first. In 1974, thanks in part to Alan Greenspan, then economic adviser to President Ford, Americans were urged to wear "WIN" buttons, standing for "whip inflation now." Those buttons were quickly discarded when it turned out that a more devastating enemy was the recession that had started in 1973 with no one noticing.

Well, not exactly nobody-the stock market clearly noticed. The year 1974 was one of the worst ever for stocks. Between the start of the oil embargo in December 1973 and their low in 1974, big-cap stocks as measured by the S&P 500 plunged by over 30 percent, while smaller-cap stocks suffered even more damage. With the exception of gold stocks, nothing was spared.

For the remainder of the 1970s, with oil uptrended but not abruptly so, and inflation seemingly on a permanently higher plateau, stocks treaded water. But then the dramatic rises in oil prices at the end of the decade and early in the 1980s-the result of political turmoil in the Middle East-hit the economy and the stock market hard. Between 1980 and 1982, the economy suffered through two recessions as unemployment soared into double digits. Stocks bobbed and weaved and in the end generated negative real returns for the period.

Then, however-as oil prices subsided and then dropped sharply throughout the 1980s, from their high of near $40 a barrel to a low of around $10 a barrel in 1986-a striking turnaround occurred. In the summer of 1982 a great bull market began. The Dow rose from a low of 780 in August of that year to a high of 2700 in 1987, and bonds soared as well. It was one of the strongest and longest bull markets ever. The economy was in high gear as well: economic growth was steady and strong, while inflation was decisively tamed, falling from the mid-teens at the start of the period to just a trace above 1 percent for the broad-based consumer price index (CPI) by the end of 1986. In short, it was an economically ideal period that was the mirror image of the 1970s. And it was made possible by well-behaved oil prices.

This period of nearly unmatched prosperity basically brought about the end of the Cold War, by giving us the ability to build up our defense establishment to the point where the Soviets simply could no longer compete. The triumph of capitalism was, seemingly, a great victory for the U.S. and the West, and not surprisingly it dominated the headlines and op-ed columns of the time. But it's clear in retrospect that everyone failed to appreciate the underlying dynamics that made our triumph possible. Oil was the silent dignitary at the table, the one that secretly held all the cards. The correlation between oil and economic prosperity was powerful and it was there for all to see, but no one was paying attention. The issue that is coming to a head now-that will determine our fate and possibly even our survival in the twenty-first century-was nowhere on our radar screens at a time when we more easily could have done something about it.

In 1987, we briefly experienced the flip side of the oil/prosperity correlation. As oil prices began to rise again, into the mid-teens-low by the standards set in the 1970s but high compared to the benign levels of the 1980s-other commodities rose as well. Inflation climbed back to above 4 percent, and the dollar began to tumble. Predictably, stocks, which had been soaring for five years, began to falter during the summer of 1987 as well. The wavering culminated in one of the worst market sell-offs in history. On Black Monday, the Dow Jones Industrial Average plunged more than 500 points, and for the month stocks fell by more than 30 percent.

Staggering as the crash was, it actually marked the only time since 1973 that a sharp rise in oil did not end up triggering economic recession. The reason: because inflation was at still-manageable levels, the Fed had the leeway to pump sufficient money into the economy to ward off a downturn. The drop in 1987 turned out to be just a temporary dip on the road to even greater prosperity and much higher stock prices. For the three years following the 1987 crash, with oil prices essentially a nonevent, the market was in high gear. By their highs in 1990, stocks not only had recovered the ground lost in the 1987 crash but were more than 20 percent above their 1987 highs.

All was right with oil, all was right with the world, and investors were making money hand over fist.

This euphoric period lasted until Saddam's invasion of Kuwait sent oil prices spiraling up by over 50 percent in just a few weeks, to more than $30 a barrel. The economy began its first recession in almost a decade, and stocks were pummeled.

As noted above, though, it quickly became clear that Saddam lacked the ability to cripple oil production. And as oil prices collapsed back to the high teens, the recession ended. Stocks once again embarked upon a bull run-and this one was to be a bull run for the ages.

Between 1991 and 2000, with oil prices remaining well under control, stocks staged one of the greatest rallies any financial market has ever seen. If you had invested in the S&P 500, say, by buying the Vanguard 500 Index Fund, in January 1991, you would have gained on average 20 percent a year for the next nine years. To put it differently, a $10,000 investment would have turned into more than $50,000. And because those nine years were ones of low inflation, your gains were mostly real gains in terms of their actual purchasing power. Moreover, as everyone knows, while the market as a whole was thriving, the tech sector, especially as the decade drew to a close, was on a real tear. All in all, these were unforgettable years, in which growth seemed to be on an ever-rising trajectory while inflation remained a virtual no-show.

Copyright © 2004 by Stephen Leeb and Donna Leeb

About the Author

Stephen Leeb is the president of Leeb Capital Management and editor of the prestigious newsletter The Complete Investor. Renowned for finishing among the leaders in the Wall Street Journal's and Forbes's annual stock-picking contests, Leeb is the author of four previous books. His wife and longtime collaborator, Donna Leeb, has a diversified background in business writing and holds a master's degree in journalism from Columbia University.