Our Amazing Oil Indicator

Excerpted from

The Oil Factor: Protect Yourself-and Profit-from The Coming Energy Crisis

By ,

We've delineated in broad strokes how since the early 1970s rising and falling oil prices corresponded to periods of weakness and strength in the economy and financial markets. Here we'll zoom in on the stock market and show you how to use oil prices on an ongoing basis to ensure that you are in the right stocks at the right time. It will become clear just why we said earlier that oil would be our "desert island, one phone call" indicator of choice.

The basic underlying relationship to grasp is that abrupt and steep rises in oil prices are hard for the economy to absorb and hence bad for stocks. By contrast, falling oil prices, or even prices that rise but do so fairly gradually, permit the economy and stocks to flourish. Why is this so? Well, imagine you found out your salary was being cut. If it was just a small cut, you might grumble but you could adapt-you wouldn't have to make major changes in your lifestyle. If it were slashed a lot, though, it would be a different story. That idea is at the heart of our indicator. The rest is details-determining exactly how to define abrupt rises and gradual rises so as to formulate the most useful investment guide.

Oil Moves and Stocks

First, let's look in more detail at how stocks have responded to various moves in oil prices. Figure 2a, "Oil Prices and the S&P 500," depicts oil prices and the stock market since 1973, summarizing the maximum losses and maximum gains in the market-as measured by the S&P 500-within eighteen-month periods following moves in oil prices. These results give a snapshot of how much risk you face when you buy stocks after various moves in oil.

Here's how we constructed the table. We looked at oil prices from the start of 1973 through the first quarter of 2003, noting where they were at the end of each month during those years and then comparing that price to their price twelve months earlier. Then we looked at where the S&P 500 index stood at the end of each month compared to where it stood one month later, two months later, and so on, for eighteen consecutive months.

The results are staggering. When oil rose by 100 percent or more over a twelve-month period, stocks during the next eighteen months experienced an average maximum monthly decline of 27 percent. (To better understand what "average maximum decline" means, suppose there were just two months in which oil prices were more than twice as high as they were twelve months earlier. For example, suppose in February 2000, oil prices were twice as high as they had been in February 1999, and in June 1974, prices were double their June 1973 level. In the eighteen months following February 2000, stocks in their worst month lost 34 percent of their value, while the worst loss in any of the eighteen months following June 1973 was 26 percent. Add 34 to 26, divide by two, and you get an average maximum loss of 30 percent. As it happens, there were fifteen months in which oil prices were more than double their year-ago levels. Thus the average maximum comes from averaging fifteen worst losses rather than just the two.) Note that we're not talking about what stocks did from the start of the eighteen-month period to the end-we're looking at their behavior at periods within that time span.

In no instance did stocks fail to experience at least one period of sharp decline. The smallest decline was 13 percent. True, sometimes stocks recovered by the end of the period, but never by much.

It's clear from the above that during the eighteen months following a 100 percent rise in oil, there also were times when stocks rose-it wasn't straight down. But when you look at stocks' maximum gains during the eighteen months following a 100 percent rise in oil, the average maximum gain was only 4 percent.

In other words, when oil prices doubled in a twelve-month period, if you had stayed out of the market, you risked missing, on average, a mere 4 percent gain at some point during the next year and a half. But if you bought stocks instead, you were more likely to sec them shed 27 percent at some point during the next eighteen months. You stood to lose a lot and at best to gain just a little. These results are particularly compelling because they occurred in the context of a thirty-year period in which stocks were sharply uptrended. The evidence is overwhelming that no investor should buy stocks without first looking at the recent direction of oil prices.

When oil prices fell, the risk/reward ratio reversed, and dramatically so. Whenever oil prices dropped over a twelve-month period, during the next eighteen months, while there may have been periods during which stocks declined, the average maximum decline was only 1 percent. Meanwhile, the average maximum gain in stocks during that same eighteen-month period was a sparkling 30 percent. A 30:1 reward/risk ratio is almost too good to be true, but true it is. Believe in it and use it.

Tags: Career & Money

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