Macro Wrap – Are Lower Commodity Prices Good or Bad for Stocks?

by Enis April 18, 2013 7:37 am • Commentary

Reminder: Dan and I will be Hosting a Free Webinar on Monday April 22nd at 4:15pm EST previewing AAPL’s Q2 earnings report and we will debate 2 options trade structures that we are considering to play the event.  Register here:

Macro Wrap 4/18/13:  With the mini-crashes we’ve seen in commodities in the past few weeks (or full crash if talking precious metals), the debate about whether falling commodities are good or bad for equities has resurfaced.  Clearly, it’s good for the consumer if gas prices go down.  And it’s good for the retailer if cotton prices go down.  It’s positive for industrials, airlines, and homebuilders if input costs like oil, jet fuel, and copper go lower.  It’s a clear positive, and I’m not denying that.

However, there is a coincident concern when market players see falling commodity prices.  It implies lower demand, and lower future growth, and thus (arguably) lower future profits.  The argument usually ends with an equity bull arguing that the decline in commodity costs is more relevant than any “signal” about future growth.  And the equity bear counters that the “signal” about growth is much more important than any slight cost benefit to end-users.

Having heard these sorts of arguments for almost a decade now – from 1983 to 2003, almost no one cared about commodity prices, since they never went up – I’ve developed a bias based on my own trading experience.  When my sole sector focus was trading materials and energy stocks from 2006 to 2008, I was usually rooting for higher commodity prices.  My sector was hot, clients were trading, there were trend opportunities, and most importantly, stocks were moving.  Meanwhile, the consumer discretionary and financial sectors started to get hit, with many arguing that it was due to higher gas prices.  In the end, whether that was simply prudent anticipation of the financial crisis, or due to gas prices crimping the consumer, is not as clear now as it seemed at the time.

Regardless, when commodity prices finally started to decline in mid-2008, many traders in the retail and financial sectors (and many broader market equity bulls) breathed a sigh of relief.  Finally, a relief for our sectors!  And boy, did commodity prices decline.  Oil went from 140 to 40 in a matter of months.  So much lower input costs were a huge boon to end consumers, right?  They were a boon, but not even close to offsetting the massive hurt from lower global demand.

2008 is an extreme example, but even when I look at the correlation between oil and stocks over the last 3 years, the “signal” that commodities send about global growth seems to have much more weight than any benefit to stocks from lower input costs.  The 3 year chart of front-month WTI oil (green) vs. the SPX index (orange):

CL1 vs. SPX, 3 year daily chart, Courtesy of Bloomberg
CL1 vs. SPX, 3 year daily chart, Courtesy of Bloomberg

This is not meant to be a chart to demonstrate that oil and stocks need to “converge” for any reason.  Rather, I just want to point out that stocks broadly have done much better when oil prices are rising than when oil prices are declining.  I’ve circled in red the top in oil in 2011, 2012, and so far in 2013.  During the months following those tops, stocks had a much rougher time than when oil was steadily appreciating.

This simplifies a complex discussion, but I’m much more interested in price action than theoretical debates.  And price action tells me that stocks are better off when oil is going up than when it is going down.