Oil and Stock Prices: An Opportunity for Fundamental Investors

U.S. stocks are lower in early afternoon trading on Tuesday, with the Dow Jones Industrial Average (^DJI 0.67%) and the S&P 500 (^GSPC 0.87%) down 1.09% and 1.05%, respectively, at 1:34 p.m. ET.

Image source: The Motley Fool.

In this daily column, I have mentioned the price of oil multiple times recently in connection with the daily action in stock prices. And I'm not the only one who has noticed what appears to be a link between equity prices and oil. On the front page of Yahoo! Finance today, I found the following headlines:

Dow falls 100 points after consumer confidence; oil eyed --Reuters

Why Stocks and Oil Dance Together --Bloomberg

It would appear, then, that as the price of oil has collapsed over the past 20 months, the relationship between the two has strengthened. Do the numbers verify that observation?

The answer is yes. Using Bloomberg's regression analysis function, I calculated the correlation between daily returns on the S&P 500 and the active West Texas Intermediate crude oil futures contract. The following table summarizes some of the results:

Data source: Bloomberg.

Correlations vary between -1 and +1. Two variables that exhibit a perfect positive linear relationship have a correlation of +1 and are said to be perfectly correlated.

The data shows that the correlation has increased as oil has declined (compare lines two and three in the table) and it has increased markedly over the past couple of months. What to make of this development?

First, is there an objective causal link between the price of a barrel of oil and equity values? Yes: Oil is a cost to every business, directly or indirectly, to some degree or another (think of airlines as an extreme example, for example). All other things equal, lower oil prices ought to result in higher earnings (with the energy sector as the most obvious exception), and that is a positive factor for equity values.

Of course, quantifying that impact is no easy task. Furthermore, beyond the fundamental impact, there is a second-order impact on sentiment.

For example, traders may consider that the price of oil is an indicator of future economic activity and that lower oil prices signal a slowdown (and vice versa: higher oil prices foretelling increased economic activity). That, in turn, would hurt corporate earnings, so, on that basis, equity values ought to be marked down.

When it comes to short-term movements in stock prices, it's very likely that the second-order effects that impact sentiment dominate any fundamental considerations.

Howard Marks, the chairman of Oaktree Capital Management and author of the excellent The Most Important Thing, told Bloomberg Television last week that "the fact that stock prices go up when oil prices go up really proves that most people don't know how these things work."

My intuition is that he's probably right -- and it's exactly these type of misunderstandings that create short-term dislocations between price and value. Ultimately, that spells opportunity for long-term fundamental investors. Bring on the higher correlations!