What Oil Is Telling Us About the Stock Market Right Now

Over the past three weeks, as markets of every stripe have been in turmoil, everyone is looking for an indicator. What can data points or other markets tell us about stocks? Is the worst of the drop over, or are the up days just an exaggerated dead cat bounce (a market term for a retracement of a down move that means nothing on the basis that even a dead cat will bounce if you throw it to the floor hard enough), and will we be seeing new lows before too long?  Everybody has their own favorite indicator that they believe will give them some insight into the future. Mine is crude oil.

When I left the interbank forex market, something that happened more than twenty years ago now, my first thought was that if I wanted to trade in my own account, foreign exchange was a logical place to start. I had, after all, spent twenty years immersed in that market and understood its influences and tendencies. I quickly came to realize, however, that trading from home, without seeing order flows or what other big players were doing, was a lot more difficult than doing so in a well-connected dealing room.

So, I started to cast around for something else to trade. Stocks seemed the obvious choice, but the more I looked at the stock market, the less inclined I became to get involved. Firstly, while I had always tracked US stocks, I had never done so in any detail and, having just moved to the country, I felt that I lacked the kind of deep, intuitive understanding of American companies…

Over the past three weeks, as markets of every stripe have been in turmoil, everyone is looking for an indicator. What can data points or other markets tell us about stocks? Is the worst of the drop over, or are the up days just an exaggerated dead cat bounce (a market term for a retracement of a down move that means nothing on the basis that even a dead cat will bounce if you throw it to the floor hard enough), and will we be seeing new lows before too long?  Everybody has their own favorite indicator that they believe will give them some insight into the future. Mine is crude oil.

When I left the interbank forex market, something that happened more than twenty years ago now, my first thought was that if I wanted to trade in my own account, foreign exchange was a logical place to start. I had, after all, spent twenty years immersed in that market and understood its influences and tendencies. I quickly came to realize, however, that trading from home, without seeing order flows or what other big players were doing, was a lot more difficult than doing so in a well-connected dealing room.

So, I started to cast around for something else to trade. Stocks seemed the obvious choice, but the more I looked at the stock market, the less inclined I became to get involved. Firstly, while I had always tracked US stocks, I had never done so in any detail and, having just moved to the country, I felt that I lacked the kind of deep, intuitive understanding of American companies and the American economy that such an undertaking would require.

After a while, I settled on oil futures as the best market for me. Oil is, like forex, a global market that is sensitive to economic and monetary conditions and very focused on growth. Those fundamental factors drive long-term moves and trends but within those trends, technical factors drive two-way, short-term moves. That is the same setup as the forex market, and that, I felt, gave me an edge when I started trading crude.

What I quickly came to realize, though, was that the global outlook and growth focus of energy traders often made them very good forward indicators of stock market moves. The pandemic crash in 2020, for example, started in crude futures about a month and a half before stocks reacted.

The above charts represent crude futures (top) and the S&P 500 (bottom) and, as you can see, crude turned downwards very early in January, while stocks kept climbing into the second half of February. There have been many other, less dramatic examples over the last five years of crude anticipating problems or starting to bounce back well before stocks, but space doesn’t permit showing all of the charts.

So, what does all this say about what is happening now?

Well, as Donald Trump has softened his stance on the things that caused the crash: the trade war with the rest of the world and calling for the removal of the Fed Chair, stocks have bounced back strongly. Crude has recovered to some extent too, but in a far less dramatic manner, recovering only around a third of its losses versus close to two thirds for the stock market.

That may, in part, be because energy traders generally take a longer-term view of any news that may emerge. They tend to react to what the news will lead to, rather than to the news itself. That is why crude dropped early in 2020, even as the government here were reassuring us that Covid was a Chinese problem, or nothing to worry about at all. Energy traders saw it differently, understanding as they did that in the modern world, if China sneezes, everybody else catches Covid, so to speak.

What we are seeing now, with the muted rebound in crude, is somewhat similar. Oil traders understand two things that seem to have eluded the stock market. The first is that whatever Donald Trump says should be taken with a grain of salt. He says what he needs to in order to deal with an immediate problem, but sees those words as just a negotiating tactic, not a commitment to action. Thus, with stocks plummeting, he said what the market wanted to hear, but what he said tells us nothing about his actual intentions. The fact that on Thursday, China announced that, contrary to what Trump had implied, no trade talks were taking place proves that once again. And if you think that the President will just leave Jay Powell alone if he keeps rates at a level that will exacerbate economic growth issues while Donald is in the White House, you haven’t been following the Trump business or political careers very closely.

Second, given the history of oil as a geopolitical weapon subject to sanctions, import bans, and tariffs for decades, energy traders are all too aware that there are no winners in a trade war, at least as far as the oil business is concerned. If America “wins” in its tit for tat battle against China, that will presumably involve weakening the Chinese economy, the world’s largest oil importer. If they don’t, then we are set for a long, slow strangulation of free trade around the world. You don’t have to be an avid Adam Smith fan to realize that that would not be good for global growth. Either way, oil suffers.

Some of the lack of enthusiasm in the oil market is due to issues specific to the commodity, but not all of it. There definitely seems to be a feeling amongst energy traders that no matter what Donald Trump may say, we are heading for a period of chaos that will restrict growth, both domestically and globally. They could be wrong, of course, but history suggests they are right. That is why I am still sitting on a substantial cash position.

I have started, as I indicated last week, to nibble at some oil stocks on the basis that either oil will realign itself with stocks, in which case oil stocks will jump, or the oil market will be proven correct in its skepticism, in which case oil stocks will outperform as a more defensive play. That, however, will involve only around 10-20% of my available cash. The rest will continue to sit on the sidelines for a while based on my belief that oil is one of the best forward indicators for the stock market, so the relatively weak bounce that we are seeing in black gold is a warning not to get too enthusiastic about stocks quite yet.