Thursday, November 8, 2012

Stock Markets and Oil Part II: Changing Market

Brent vs. WTI
The S&P500/Oil divisor used in the first part of this series runs only from 1986 to present. Using WTI (West Texas Intermediate) prices, the divisor can be tracked from 1957 to the present (because that is as far back as data goes back at FRED).   Brent prices were used earlier because the recent mid-American oil bottleneck has lead to a significant price spread over the past two years.

SP500/Oil divisor from 1957 to present using WTI (West Texas Intermediate).  Mean=22.20. Median=19.75

Saudi Arabia - Game Changer
Oil prices increased throughout the 1970s after the 1973 OPEC oil embargo and again later, due to the Iranian Revolution.  Iranian oil production picked up toward pre-revolution levels in the early-1980s, to fund normal government functions and itss war with Iraq.  Oil prices declined from their $40 peak in 1980 to $30 by 1985.

S&P500/Oil divisor from the embargo to the 1986 price collapse. The divisor bottoms out during the Iranian Revolution and begins to climb back up starting in 1982 (the beginning of a two decade long secular bull market).
In 1986, Saudi Arabia flooded the market with oil - causing prices to collapse.  The collapse in prices put further downward pressure on American real-estate prices in the oil states (which had already experienced considerable unemployed in the early-1980s) which facilitated and accelerated the 1980s S&L crisis.  The move by Saudi Arabia had a few other world changing consequences.

Cluttered explanation of oil and stock market relationship in a scatter plot. Data is taken quarterly from Q1 1957 to Q3 2012.  Black line connects the dots from one quarter to the next.
The Changing World Order
On July 15, 1971, Richard Nixon announced his decision to visit China.  One month later, on August 15, Richard Nixon signed the 1971 Economic Stabilization Act which ended the old era gold standard.  Think about that for a moment.  Within one month's time, the president had announced the direction for a new US economic model - trade with China using a new fiat currency. 

Within 18 months after the end of the gold standard, Nixon visited China and ended the Vietnam War.  The 1971 Economic Stabilization Act also created rent, wage and price controls.  Besides all of that, Nixon helped create the EPA, signed into law supplemental and cost-of-living adjustments (COLA) for Social Security, and, in his 1974 state of the union, stated that it is the goal of the government to create a system to provide affordable healtchare to every American.  Not bad for a once staunch anti-communist - or as they say "Only Nixon could go to China".

The First Order of Business
The OPEC oil embargo not only lead toward higher oil prices but also created a dollar pricing mechanism.  The various OPEC nations, during the embargo, agreed to price (and many to sell) their oil exclusively in American dollars.  The resulting high oil prices lead to rising inflation and decreasing growth for the rest of the decade - known as stagflation.  However, the OPEC-dollar pact meant that oil consuming nations would experience the pain of both higher oil prices and fluctuating US exchange rates.
To combat the rising inflation, happening in the US and Europe, central banks raised interest rates to curb government spending.  In the late-1970s, the increase in interest rates helped to contract the US budget deficit as a percent of GDP.  However, despite the high interest rates the US budget deficit as a percent of GDP widened from FY (fiscal year) 1980 to 1986 - earning debt holders considerable bucks at the high interest rates.  In the late-1980s, the budget deficit as a percent of GDP would again begin to contract.

Interest rates on government debt (blue) and US budget balance as % of GDP (red) from 1957 to present. Low oil prices and large capital gains tax receipts lead toward a rare event: the US budget surplus of the late-1990s.

The Double Dip
The US experienced two recessions in the early-1980s.  The first, a large increase in oil prices lead to a surge in inflation and operating costs.  The second (the double-dip), despite the Federal Reserve's actions to increase interest rates, inflation continued to rise as oil prices stayed high even though they declined. 

To combat each recession, the Federal Reserve halted its policy of increasing interest rates, and reduced interest rates to ease the flow of credit for investment.  However, after the double dip recession, unemployment rates fell but plateaued at levels above the pre-recession levels of the late-1970s. The unemployment rate did not decrease to pre-recession levels until 1986 when oil prices collapsed.

S&P500/Oil divisor (green), interest rates (orange) and the unemployment rate (yellow-green).

The Fall of a Giant
The cheap oil of the 1980s was the straw that broke the Soviet Union's back. Heavily dependent on oil sales for government revenue, and engaged in war in Afghanistan, the Soviet Union's government revenue greatly decreased when oil prices collapsed.  The Soviets experienced a crisis that was beyond their control.
Iraq and Iran, at war with each other from 1980-1988, were also hard hit by the oil price collapse.  Funding for their war had to be scaled back; eventually ending in a truce.  Because the Soviet Union was the largest supplier of weapons during the war, they experienced even further decline in government revenue.  Later, Iraq would invade Kuwait in protest of war-related debts (denominated in dollars) it could no longer pay.
In all, Saudi Arabia's increased oil production may have indirectly saved tens of thousands of lives, and spared many more people from the misery of war and the oppresion of communism.  However, in relation to the American stock markets the effect may have not had an immediate impact.  It helped to further put Americans back to work as cheap oil meant cheap transportation fuel - setting the stage for the 1990s' stock market boom.

Shiller PE/Oil divisor (black) - this is Robert Shiller's PE Ratio divided by the price of oil (Shiller does not actually produce such a data set).   PE/Oil has not recovered since the embargo.   The oil price used here is actually a WTI annual-average, indexed to 2005 (via FRED).   Shiller PE data at

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