Oil and the Market

Just a few days ago oil reached $112 a barrel.  I have been harping on inflation for a while but even I was shocked to see that gasoline prices are above $4.55 a gallon here in San Diego.  That hurts.  Regardless of this fact the stock market continues to trend higher.  This cannot continue.  Oil prices feed into everything and every business is affected by this increase to some degree.

On the one side you have oil companies and oil service providers.  Certainly they are the major benefactors of these price increases.  On the other side you have transportation companies that are trying to pass along the massive increase in their variable expenses to an already strapped consumer.  Furthermore you have a consumer that is unable to find a job and now has to pay 30% more to fill their tank up with gas.  This will bleed into their budget and squeeze the life out of a recovery.

So when does the market wake up and reflect this in the price of stocks?  Certainly these prices do not feed into the market immediately.  Oil prices are notoriously volatile and so the market will discount this for a while and certainly it has for the past year.  However oil prices did not reach $112 a barrel overnight.  This process has been developing for over a year as back then oil prices were less than $50 a barrel and have increased over 100% since. 

At present the market remains resilient as market participants continue to buy the rhetoric from the Federal Reserve that inflation is under control.  However, with earnings season upon us the proof will be how well companies have handled the increase and what effect is has on both their margins and their outlook.  Sustained oil prices above $100 a barrel will squeeze the consumer and companies and will shave at least 1% off GDP growth.  This will derail the recovery and will undermine the stock market advance.

So how sustainable are the current oil prices.  Remember that when oil prices advanced to $147 a barrel in July 2008, they quickly fell back to below $50 a barrel six months later.  That said the damage was done and the market fell with the drop in oil prices.  The high in the price of oil interestingly corresponded with the bursting of the bubble in real estate.  I believe that there is a correlation between the two to some degree as the massive increase in oil prices took the consumer to the edge and assisted in breaking the bubble (not that it would not have broken anyway).

The point is that back then the housing bubble and the energy price was driven by a massive influx of capital from loose credit.  Back then the credit given was to the consumer who used it to finance housing purchases and this fed into a frenzy that drove the trade deficit into a massive negative.  Fast forward to today and the consumer is still trying to get out from under the massive blanket of debt.  The economy is still weak and in the place of the consumer we have the Federal Reserve who is buying all the junk that the banks and the consumers held.  In order to buy this junk it is printing massive amounts of cash and pumping it into a fragile system.  The market has reacted by debasing the US dollar and driving the prices of all commodities higher.  The main difference between the two stories is that when the ship sinks this time it is not the US consumer that will go down but the credibility of the Federal Reserve and with it the markets of the world.

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