Over exaggerating market relationships
It is good to have an understanding of underlying relationships between assets. Knowing that gold goes up when the dollar goes down or that airlines and consumer discretionary stocks do not benefit from higher oil prices is important for someone trying to understand the market. However, sometimes these relationships are given an importance that masks what is really going on. Howard Simons has an article up at Minyanville that makes this mistake.
“The current partial contribution of crude oil prices to the S&P 1500 Supercomposite remains positive, 0.59% on a net weighted beta at last calculation. The reason for this is simple: The positive impact across the Energy and Basic Materials sectors outweighs the negative impact across the Consumer Discretionary, Consumer Staples, and Health Care sectors.
He is right that higher oil prices are generally better for Energy and Basic Materials sectors than for the others. Energy companies selling oil and oil services make more money when oil is higher, and oil is highly correlated to the price of many other commodities that materials companies make money selling. However, implying that the S&P 1500 was driven up despite the negative effect of oil on consumer discretionary stocks is proved false by simple data analysis.
The chart below shows the weekly percent change of oil versus the weekly percent change of the AMEX Consumer Discretionary Select Index from March 2009.
The relationship between oil and consumer discretionary stocks is positive, as both have been rallying due to more positive economic and financial expectations. The more intuitive relationship of higher oil prices mean consumers have less money to spend on everything else is masked by the more extreme financial market effects. Simons does recognize this factor when he discusses that global economic growth is partially behind the high correlation between crude and the S&P 500, but it doesn’t make his earlier statement about sectors any more correct.
The below chart looks at crude oil weekly returns vs. the relative beta adjusted weekly return of the consumer discretionary stocks (Consumer Discretionary weekly return times beta to S&P500 minus S&P 500 weekly return). Since October 1st, even this relationship has been slightly positive.
The chart below shows how the relationship between crude oil and the S&P 500 is variable over time (The rolling 26 week T-stat of crude oil explaining the S&P 500). Theoretically, the relationship is positive when crude oil and the stock market are being driven by economic growth and it is negative when oil is acting more of a constraint on growth due to supply restrictions. When the oil squeeze comes, this chart will fall below zero.
The charts were made with tools from Palantir Finance, which released some good news today.
