In case you have been ignoring the market news lately, stocks have been under an assault unlike any we've seen in years. Last week, the Dow Jones Industrial Average (DJINDICES:^DJI) gave up 3.7%, its worst one-week decline in over three years, while the broad-based S&P 500 (SNPINDEX:^GSPC) dropped 3.5%, its largest weekly drop in two-and-a-half years.
This week's been a bit more of a seesaw, so we still haven't recovered the losses from last week. Oddly enough, the major reason for the sell-off, falling oil prices, which provide a huge benefit for consumers, should be a good thing for the American economy and the stock market. Before examining the reasons for that, let's take a look why the oil shock caused such a dramatic sell-off in the stock market.
The market does not like uncertainty, and oil prices falling nearly 50% since June have taken everyone by surprise. Yes, rising U.S. production and slowing growth in China explains part of the dip, but that alone doesn't account for such a strong shift in the equilibrium price. Speculation and OPEC's decision to maintain production to keep market share and force out U.S. shale producers have also contributed to the plunge. No one knows if and when oil prices could snap, and in general, the market prefers stability, especially in commodity prices.
Adding to the market's uncertainty has been the pressure that tanking oil prices have put on the ruble. The Russian currency fell as much as 23% against the dollar Tuesday, hitting an all-time low despite a massive hike in interest rates, and tightened the squeeze on an economy that's already struggling due to the drop in oil prices and sanctions stemming its invasion of Ukraine. Not only is Russia one of the world's biggest economies, but its also run by one of the world's more volatile regimes with its invasion of Ukraine and partnership with Iran. The crisis also presents a political challenge for Vladimir Putin, which could also lead to unforeseen consequences.
All of this volatility and uncertainty has caused investors to make a "flight to safety," trading riskier assets such as equities for safer ones like treasuries and other bonds.
Lower oil prices are also bad news for much of the energy sector, including majors such as ExxonMobile and Chevron as well as smaller exploration and production companies, but despite the volatility concerns, the development is still good for the economy. Here's why:
Consumer spending accounts for approximately 70% of economic activity in the U.S., and the savings from lower gas prices have been huge. Goldman Sachs estimates American consumers will save between $100 billion-$125 billion next year, with the majority of that benefit going to the middle class. The Wall Street Journal also examined the effect of lower oil prices on every economy in the world, and found that the U.S. GDP would grow by $90 billion if oil prices averaged $71 for year. The benefits increase the more the price of oil goes down because, despite the growth of the energy sector, consumer spending is still a much larger factor in the national economy.
Indeed, U.S. consumer confidence rose to an eight-year high last week, thanks to lower gas prices and an improving employment picture, hitting a mark of 93.8. So those savings at the pump should show up on the bottom line for many retailers, especially those like Wal-Mart that cater to lower-and-middle income shoppers who benefit the most from lower gas prices. Another industry poised to reap the benefits of the oil drop is the airline industry as fuel makes up close to half of their costs. The crash is expected to produce a windfall of $12 billion in the industry globally, and profits are projected to increase 25% to $25 billion next year. Also as an example of the effect on individual airlines, in the last 90 days, next year's per-share profit estimates for United Continental have gone from $5.95 to $7.82. Lower gas profits also benefit other parts of the transportation sector, and provided a lift to auto sales in November.
Since corporate earnings are the primary factor underpinning stock prices and lower oil prices encourage consumer spending, the fall in oil prices should help benefit the stock market over the long-term. In the short-term, concerns about instability and unknown consequences in Russia and elsewhere could continue to push the market down, but considering the U.S. economy is driven by consumer spending, I think lower oil prices will be a positive in the end.