Could Oil's New Highs be a Bad Sign for Stocks?

Could Oil's New Highs be a Bad Sign for Stocks?

I learned a long time ago to trust pricing and data over feelings when it comes to financial markets. Sometimes, however, what starts as a nagging feeling in the back of your mind forces its way to the forefront and needs to be confronted. If said feeling cannot be dismissed logically at that point, you should start paying attention.

I have had a feeling for some time that the search for a return has become a search for risk, with money rushing from one risky asset to another with increasing frequency, creating a series of mini-bubbles. That contention is still explainable, and the exits have to this point been orderly, but if the current asset du jour, oil, goes out of favor and gives up recent gains, it will have a far larger impact on stocks.

It’s time to take my feeling seriously.

Oil is generally considered to be an indicator of potential growth, with the price responding to the overall degree of optimism among fund managers worldwide. When supply is the obvious driver of oil prices that is not the case, but otherwise U.S. stocks often take their cue from the U.S. oil benchmark, West Texas Intermediate (WTI).

That price has been on a tear now for several months and is currently at levels not seen for years, despite increasing domestic supply. Encouraged by the higher prices, U.S. producers are pumping like crazy, and the current White House is opening up drilling grounds and selling leases like there is no tomorrow, but WTI keeps climbing.

That would indicate that, despite the cuts by OPEC et al, this is not a supply-driven move. The obvious assumption, then, is that traders and investors everywhere see massive gains in economic activity ahead, and that is lending support to stocks. There could, however be another reason the big money is moving into oil, and it has nothing to do with the economic outlook.

Capital always seeks a return, and, even as the Fed moves towards further rate increases, low interest rates continue to drive money out of bonds and into other, riskier markets. That has led to a situation where the stock market has been the beneficiary, with an increasing base of capital chasing a limited supply of shares, but value is becoming increasingly scarce.

So, with profits on existing positions allowing for it, diverting funds into riskier assets has become popular. The most obvious example of that is in cryptocurrencies, but as the bitcoin price has retraced, there is evidence that money is already creating the next mini-bubble by moving into not just oil, but commodities in general.

Take a look at the two charts above. The first is from Coindesk, showing three months of BTC/USD action. The second is for DJP, a commodities ETF with only around thirty percent exposure to energy. Now it could be a coincidence that DJP started its steep climb in mid-December just as BTC/USD hit its high and turned, but if you accept that there is a large pool of money out there desperately seeking high returns, it looks more like a rotation than a coincidence.

Normally that would only be a problem for those engaged in those risky markets, but oil’s aforementioned traditional role as an indicator of growth potential means that is not the case right now. If the fast, risk-seeking money is driving oil higher at the moment then at some point soon, profits will be taken, and a downward move will result.

At that point the reality of massive supply increases just as the world moves away from gas powered vehicles will become the focal point, and a real collapse that drags stocks with it is a distinct possibility.

I realize all too well that the above is series of assumptions, one on top of the other, but that is what forward thinking looks like. I also realize that, for stock market investors, timing is still an issue. The economic fundamentals in the U.S. and globally are strong and corporate profits are increasing enough to justify valuations, but average P/Es are still creeping up based on expectations of strong growth.

That could continue for a while, so selling in anticipation of a collapse would be as wrong-headed now as it has been all the way up. Still, I will be watching for a turnaround in oil, and ready to hedge my portfolio when it comes, and you should be too.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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