March.08, 2022 - Major Oil Price Increases Cause Bear Markets

Many know that rising interest rates and spikes in oil prices cause problems
in the economy and the stock market. However, how much of an increase is too
much? Many know that rising interest rates don't usually cause a recession
unless short-term rates (3-month T Bills) are higher than long-term rates (10-year
bonds). This is called an inverted yield curve.

 

On the other hand, I have found that very few are aware of the work by Dr.
Stephen Leeb in Oil Factor, where he clearly defined how much of an increase in
oil prices is too much. He found that an increase of 80% or more over a 12-month
period eventually caused a bear market in the S&P 500. A bear market is defined
as a decline of 20% or more in the S&P 500.

 

An inverted yield curve or an 80% rise in oil prices on their own can result in
setbacks for the economy and stock markets. However, I have discovered that
when these two conditions exist at the same time, it typically produces the kind of
market declines that investors don't forget. The long and severe bear markets in
1973-1974, 1982, 2000-2003 and the 2008-2009 Financial Crisis all occurred
when the yield curve was inverted AND oil prices rose 80% or more over a 12-
month period. The only time I can recall when the economy and stock markets
had shorter, more moderate declines when both of these conditions existed was in
1990.

 

The chart on the next page produced by my colleague Cam Wilson, using
YCharts, shows when oil prices have risen over 80% in 12 months since 1987.
How much more oil prices rise above the 80% level does not seem to be
significant.

 

US stock prices fell 40% in two months during the Crash of 1987 just months
after oil prices breached the 80% threshold on the left side of the chart. It must be
pointed out that this just eliminated the gains earned during 1987. The next time
this happened was when oil prices reached all-time highs as Iraq invaded Kuwait
in August 1990. The S&P fell 20% by early 1991 until operation Desert Storm
renewed confidence.

 

Before 1990, the all-time high for oil prices was $38 in 1981. After being in a
consolidation phase for 18 years, oil prices had declined to only $10 a barrel by
1999. One year later, oil prices had increased by 100% close to 20% a barrel,
which was well below the previous highs. Nevertheless, a long, severe bear
market and recession still occurred since the yield curve also inverted.

 

Oil prices broke above the 80% level again in 2008 when oil prices reached
$147 a barrel. The yield curve inverted in 2007 and the Financial Crisis started
after Labour Day 2008. Oil prices collapsed all the way down to $33 during the
Financial Crisis. Within a year after that, oil prices had doubled as they recovered
from the extreme waterfall decline. The S&P 500 fell very close to 20% two years
later in the summer of 2011.

 

Oil prices collapsed to the $33 range in early 2016 as the commodity
consolidation phase began. Oil prices recovered and rose more than 80% from
that level in 2017 and again in early 2018. Sure enough, the S&P 500 fell just a
hair less than 20% in late 2018 when the Fed was too aggressive with raising
interest rates.

 

You may recall that prices for oil futures actually fell below $0 when Covid
swept over the world in the spring of 2020. If we use the daily low of $12.34 on
April 28, 2020 for spot prices (see green arrow on bottom left), oil prices had
risen by 80% on May 5, 2020 when prices reached $20.39. (See the red arrow just
above the green arrow weeks earlier.) The S&P 500 was only at 2,848 on May 5,
2020, so reducing equity exposure then certainly would not have been a prudent
move. This is because the S&P 500 closed at 4,170 today, which is up 46% from
May 5, 2020 even after the selloff this year.

 

If we use a more normal oil price of $36 on September 8, 2020, (see the other
green arrow) oil prices were up 80% higher than that as of May 26, 2021. (Please
see the red arrow on the right of the chart.) The S&P 500 closed at 4,196 on that
day, just a hair below the closing level today. Consequently, if investors had
reduced equity exposure in May 2021, taxes would be due on the gains outside of
registered accounts and very little would have been gained at this point. (The red
arrow on the left shows the level of the S&P 500 when oil prices rose 80% from
the April 2020 lows. The other red arrow shows when oil prices were up 80%
from the $36 level on May 26, 2021. You can see that the S&P 500 is almost at
the same level as that red arrow today.

Today, the S&P 500 is down 13.4% from the high of 4,819. Consequently, it
could drop another 7% or so from here if it were to fall 20%. Keep in mind that
market bottoms are violent volatile affairs as some investors panic as they give in
to their emotional temptations. Stock prices can fall very quickly at the end of a
decline and then turn on a dime to recover much of those losses in the days that
follow. Daily swings of 3% or 4% near the market low would not be unusual
either.

 

We have already experienced two key reversal days in the last six weeks,
which are signs that the selling was exhausted on those days. The time between
the first market low and the last is usually six to eight weeks. Therefore, in terms
of time, we are getting close to the interval where the final capitulation of sellers
could happen on any day. The level of pessimism is also close to where market
bottoms have occurred before.

 

From 2010 to the present, the S&P 500 never fell more than 20% other than
during the Covid-19 sell-off in 2020. Why is this the case? It is very simple. We
tend to think that the more prices fall, the farther they are going to fall. However,
the more stock prices fall, the more attractive they actually become. Remember
that the DJIA rose from 1,000 in 1980 to 37,000 a few months ago. So, has buying
stocks when there is a 20% off sale been a good strategy or a bad one?

 

Most of the stock market gains since 2009 have come about due to companies
buying back their own shares. When markets start falling, these buybacks stop,
making the decline worse. On the other hand, corporations are now watching very
closely so they can pounce to take advantage of these cheap prices at the first
signs of a turnaround. This is one of the reasons why market bottoms have
become such violent affairs in recent years.

 

Investors must also keep in mind that we are in the middle of a 16 to 18-year
growth phase where missing out on gains can be costly. The average bear market
in a growth cycle lasts 7 months compared to 21 months during the consolidation
phase. The average bear market decline is 21% in the growth phase compared to
42% during the consolidation phase. If history repeats, US stock prices should
triple in the next ten years or so. I believe that capturing these gains is much more
important than trying to avoid a short-term decline that can happen anywhere
from three months to 24 months after oil prices rise 80% or more.

 

Investing is an emotional affair. Investing can be more comfortable if we can
have an idea of what might happen in the future instead of being surprised by it.
This is why a number of previous Updates have discussed the fact that the risk of
a 20% decline was present due to the spike in oil prices.

 

While it seems like stock prices are falling only because of the current rise in
oil prices and the uncertainty due to the Russian invasion of Ukraine, you can see
that stock prices were already set up for a 20% decline at some point in the next
year or so. In a sense, the invasion and current jump in oil prices are only causing
problems for stock prices that were due to occur anyway.

 

Why does a large increase in oil prices cause bear markets? While interest rates
affect many people around the world, rising oil prices affect every single person.
Food and other goods all have to be moved by vehicles fuelled by oil. Rising oil
prices are like an extra tax on every person and business that takes money out of
other areas of the economy and diverts it to the oil companies. A rapid upside
move in oil makes it challenging for individuals and companies to plan ahead.
This added uncertainty negatively affects consumer and business confidence. We
must remember that confidence is the foundation and cornerstone of the economy
and stock market. Without confidence about the future, few would invest any
money and take risks. This is why oil prices and interest rates are really the two
main factors that negatively affect stock markets and the economy. History has
shown that all the other factors seem to just be distractions.

 

In summary, the sharp rise in oil prices almost two years ago was destined to
cause problems for stock prices sometime in the future. When it would cause
problems is never clear. Today, the S&P 500 is very close to where it was when
oil prices rose 80% from September 8, 2020, not from the lows in the $12 range
earlier in 2020. Stock prices could fall another 7% or so from here but that
additional decline could occur very quickly and be reversed just as fast. It is very
challenging to know exactly when setbacks like this will happen. They can be
unnerving. However, we are in a growth phase so this is likely just a temporary
decline in a longer-term uptrend that should propel stock prices much higher in
the years to come.

 

I took the photo of this 10-metre waterfall on the next page just down the road
from my house during a recent cold spell. Now the sun is out and there are not any
remaining traces of all of that ice. That is the way it is with many market
corrections as well. What can seem so important and captivating can be over with
very quickly and then the decline becomes just another statistic for a table and
another blip on a graph that many won’t really remember a few years from now.
When the correction ends and we know how it ended, the fear and anxiety ends as
well. This is why when we look back at the past it often seems better than the
present. We have uncertainty about the present but not the past because we know
how things turned out. Have a great week my friend!