Oil prices are down due to an oversupply, but this time it isn't all good news.
By Anna B. Wroblewska
The stock market is having the worst January on record. At the same time, oil prices are sinking. These two asset classes -- which historically don't have much in common -- are moving together and going south.
But why? At the heart of the matter is an oversupply of oil, which is, in turn, related to a major economic shift in China. Here's what you need to know, why it matters, and how to get through.
Oil and stocks: A recent correlation
Considering the way oil and the stock market have dominated headlines, you might be surprised to find that, historically, oil and the S&P 500 haven't had much of an effect on each other. Going back to 1973, these two asset classes usually either move independently of each other or are negatively correlated. The latter captures the times when low oil prices boost prospects for American consumer spending, moving stocks higher.
Now, however, is not one of those times. Why not?
It comes down to the supply and demand for oil. Like any asset, oil prices fall when demand falls or when supply rises -- and in this case, supply has skyrocketed compared to demand. Between shale oil production in the US, economic slowdowns in China and Europe, the emergence of Iran on the world market (among other factors), there is more oil in the world than we know what to do with. The International Energy Agency expects to see an oversupply last through 2016.
This might seem like a good thing in theory, unless you're an energy company. But the worrying part has to do with falling demand, particularly in China.
The country is facing its lowest growth rate in 25 years and an increasingly precarious debt burden -- and it looks like policymakers are struggling to control both. This is doubly unfortunate because when China falters, there's a ripple effect around the world: The World Bank estimates that a 1% decline in Chinese economic growth causes a 0.5% decline in global growth.
That, in turn, has a direct impact on American companies.
Matters at home aren't not much better
Back at home, low oil prices aren't offering the helping hand they have in the past. Normally, you might see prices falling at the gas pump and think it's good news: less money spent on gas means more money to spend elsewhere -- which should arguably boost prospects for companies listed on our major markets.
Unfortunately, this time that's not the case. Listed energy companies and materials companies are, of course, feeling the effects of falling oil prices, but consumer discretionary stocks are also falling. This highlights a troubling issue: American consumers are under pressure from so many sides that even the extra spending money that comes from paying less at the pump might not make a difference. High debt burdens, healthcare costs, and education expenses (among others) can easily suck up those gains, leaving American consumers right where they started.
In other words, from an American point-of-view, low oil prices aren't really a big bonus for consumers. Oil is also standing in as a signal for concerns about economic prospects in China and the potential effects on American companies and the rest of the world. With so much oil on the market and a lack of certainty about demand, risk might be all that market players are seeing -- for good or bad.
That sounds rather bleak, but it doesn't have to be.
If you're looking to take the long view, you'll be heartened to know that this happens periodically: oil prices fall (or skyrocket) and the market reacts (or doesn't). Instead of worrying about how you should react, try to see the forest for the trees. There has been an enormous amount of volatility, but at the end of the day it might have nothing to do with your long-term investment strategy. If you're diversified, disciplined, and able to extricate yourself from the market's feelings of panic, this could be but a blip on the radar, or even a very good time to continue your investment program.
After all, over the long run the market favors those who buy low, tough as it might be to do at the time.
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