Global Investment Strategy Global Real Assets Strategy Report: Focus on Oil January 28, 2016 John LaForge Co-Head of Real Asset Strategy Analysis and outlook for the real assets market» Commodity prices have historically moved together over long multi-year swings, called super-cycles. The average bull super-cycle has lasted 16 years; the average bear has lasted 20 years (data from 1800 to 2015).» Stock markets, like commodities, have historically moved in long super-cycles as well. But, interestingly, past stock supercycles have often run counter to commodity super-cycles (i.e. when stocks have been in a bull market, commodities have typically been in a bear market). What it may mean for investors» Commodity bear markets have historically added a positive long-term tailwind to U.S. stock markets.» We expect sinking oil prices to ultimately turn into a stock market positive, which could last for many years to come. The Investment Upside to Sinking Oil Prices As oil prices sink, many of the benefits appear to be accruing to the consumer. Michigan drivers especially, with select locations pricing gasoline sub-$0.50/gallon, may feel like they have hit the commodity jackpot. On the flip side, stock investors appear to be taking more body shots than an opponent of Manny Pacquiao. Until very recently, the equity-market damage was largely contained to those companies with direct commodity exposure. But that changed as we exited 2015. Entire equity markets are now ebbing and flowing with the price of oil. This odd action begs some questions on how stock markets have traditionally interacted with oil and other commodities, which we will address today. The bottom line is that sinking oil prices have negatively impacted stock-market performance recently. But if history is any guide, the commodity bear super-cycle will ultimately be a positive equity-market influence, which could last for many years to come. Are stocks normally this connected to the price of oil? No, they are not. From 1984 to today, the correlation has averaged close to zero. This is highlighted by the blue line in Chart 1, which represents the rolling one-year correlation of daily price changes between oil and the S&P 500 Index. 1 Yet it is worth pointing out that the relationship between oil and the S&P 500 Index has changed somewhat since 2009. The slightly negative average correlation from 1984 to 2009 has become a 1 Correlation measures how two investments move in relation to each other. The correlation coefficient ranges between -1 and +1. A value of 1 represents perfect positive correlation (as one security moves, either up or down, the other security will move in alignment, in the same direction). A value of -1 implies perfect negative correlation (the assets move in exactly opposite directions). 2016 Wells Fargo Investment Institute. All rights reserved. Page 1 of 6
positive one. As for what this might be signaling, if anything, we are not certain. Perhaps we will tackle the topic later in 2016. Do commodities, in general, typically move with stocks? This answer here is also no. More often than not, stocks and commodities lack a strong connection in the short-to-intermediate term positive or negative. The rolling one-year correlation between the S&P 500 Index and the Reuters Continuous Commodity Index (CCI) is the green line (Chart 1). Chart 1. Rolling One-Year Correlation: Reuters Continuous Commodity Index and S&P 500 Index 0.6 0.4 S&P 500 Index and WTI Crude Oil Spot Price S&P 500 Index and Reuters Continuous Commodity Index 0.2 0-0.2-0.4 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 2014 Source: Bloomberg, Wells Fargo Investment Institute 1/26/2015. Data Sample: Daily, 5/16/1983-1/26/2016. The Reuters Continuous Commodity Index is an equal-weighted geometric average of commodity price levels relative to the base year average price. Over super-long cycles, the relationship between stocks and commodities has proven to be slightly more negative. The top clip in Chart 2 represents the NDR Commodity Composite (Ned Davis Research Commodity Composite). The shaded areas in the top clip are the bear markets for commodities. The bottom clip is the Dow Jones Industrial Average, which represents equities. The shaded areas in the bottom clip are the bear markets for stocks. Notice the checkered look of the chart. When commodities have been in bear markets in the past, stocks have traditionally been in bull markets, and vice versa. The main message: sinking, and persistently low commodity prices have classically added positive tailwinds to stocks. 2016 Wells Fargo Investment Institute. All rights reserved. Page 2 of 6
Chart 2. Commodities and Stocks: Secular Bears Source: Ned Davis Research, 1/27/16. Copyright 2016 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved. Numbers outside the chart represent index values. Past performance is no guarantee of future results. The 1980s vs. Today Chart 3 shows us what happened with oil and energy stocks during the 1980s and 1990s. It is a reasonable representation of what may happen over the coming years, which we will explain. The price of oil is shown in the first clip; the S&P 500 Index is the second clip; the S&P 500 Energy Index is the third clip; and the fourth clip is the S&P 500 Energy Index relative to the S&P 500 Index. The early 1980s, interestingly, had commodity and stock super-cycle backdrops like today; commodities entered a fresh bear market in 1980, while stocks entered a new bull market in 1982. These turning points in the 1980s are marked in Chart 3 with vertical black dashed lines. It is also significant that both of these super-cycles shifted again, around the same time in 2000; commodities entered a bull market, while stocks shifted to a bear market. In our current cycle, stocks entered a new bull market in 2009, while commodities started a new bear market in 2011. Comparing the 1980s to today reminds us that cycles don t repeat exactly, but they do often rhyme. The main message: when commodities have been in a bear market, it has been common to find stocks in a bull market. 2016 Wells Fargo Investment Institute. All rights reserved. Page 3 of 6
Chart 3. Oil, S&P, and Energy Stocks During Last Commodity Bear Super-Cycle 1982 Stock Bottom 1980 Commodity Peak Source: Ned Davis Research, 1/27/16. Copyright 2016 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All rights reserved. RS=relative strength. CL is the perpetual futures contract for West Texas Intermediate (WTI) crude oil. A perpetual futures contract is a blending of all contracts within the next 91-days. Numbers outside the chart for the first clip are the actual price of crude oil in USD. Source: Commodity Systems, Inc. www.csidata.com. Numbers outside the chart for the remaining three clips represent index values. Past performance is no guarantee of future results. Points to Observe from the 1980s and 1990s Oil (First Clip) Once oil found its $10 per barrel bottom in 1986, it bounced significantly in 1987, and then settled into a $15-$25 range for the next 12 years. Occasionally, oil broke the range, for periods of stress such as the 1991 Iran-Iraq war, but ultimately, it returned to the range where it continued to work off the excesses of the prior bull market. The main message: We are expecting similar bounce/rangebound action from oil in the coming years. Once oil finally bottoms, we will be able to better understand what that future range may be. Stocks (Second Clip) The super-cycle bull market began in August 1982; ending around 2000. The main message: If stocks remain in a bull market (and once oil finally bottoms), we would expect the S&P 500 Energy Index to eventually move higher (as opposed to lower) as the S&P 500 Index moves higher. Energy Stocks (Third Clip) Once oil bottomed in 1986, the S&P 500 Energy Index moved higher with the S&P 500 Index through 2000. The main message: Once a bottom in oil is found, we would expect the S&P 500 Energy Index to move higher with the S&P 500 Index. Energy Stock Relative Strength (Fourth Clip) Once oil bottomed in 1986, the S&P 500 Energy Index stopped declining relative to the S&P 500 Index. But the reprieve didn t last. By 1988, the S&P 500 Energy Index resumed its relative strength losses until the commodity bear super-cycle ended around 2000. The main message: Until the commodity super-cycle bear ends, we would expect the S&P 500 2016 Wells Fargo Investment Institute. All rights reserved. Page 4 of 6
Energy Index to persistently lose relative strength to the S&P 500 Index. If history is repeated, the S&P 500 Energy Index will have its short periods of relative strength, particularly when oil bounces to the top end of its range, but we are not expecting the energy stock relative strength bounce to last. Risk Factors All investing involves some degree of risk, whether it is associated with market volatility, purchasing power or a specific security. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. Stocks are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Investing in commodities is not suitable for all investors. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. The prices of various commodities may fluctuate based on numerous factors including changes in supply and demand relationships, weather and acts of nature, agricultural conditions, international trade conditions, fiscal monetary and exchange control programs, domestic and foreign political and economic events and policies, and changes in interest rates or sectors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks, including futures roll yield risk. Investments in the energy sector are subject to the adverse economic events within that industry. A downturn in the energy sector of the economy, adverse political, legislative or regulatory developments or other events could have a large impact on a portfolio s investments. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. There is no assurance that any of the target prices or other forward-looking statements mentioned will be attained. Definitions An index is unmanaged and not available for direct investment. The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. NDR Commodity Composite measures a basket of commodity prices as well as inflation. It blends the purchasing manager index (PPI) and the Reuter s Continuous Commodity Index. The PPI measures the average changes in prices received by domestic producers for their output. The Reuters Continuous Commodity Index comprises 17 commodity futures that are continuously rebalanced: Cocoa, Coffee Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Live Cattle, Live Hogs, Natural Gas, Orange juice, Platinum, Silver, Soybeans, Sugar No. 11, and Wheat. The Reuters Continuous Commodity Index is recognized as a major barometer of commodity prices. The index comprises 17 equal weighted commodity futures that are continuously rebalanced: Cocoa, Coffee C, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Live Cattle, Live Hogs, Natural Gas, Orange juice, Platinum, Silver, Soybeans, Sugar No. 11, and Wheat. S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the US stock market. The S&P 500 Energy Index comprises those companies included in the S&P 500 Index that are classified as within the Energy sector. West Texas Intermediate Crude Oil is a light, sweet (i.e., low sulfur) crude oil which is the main type of U.S. crude oil traded in U.S. futures markets. Disclaimers Global Investment Strategy ( GIS ) is a division of Wells Fargo Investment Institute, Inc. ( WFII ). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. 2016 Wells Fargo Investment Institute. All rights reserved. Page 5 of 6
The information in this report was prepared by the GIS division of WFII. Opinions represent GIS opinion as of the date of this report and are for general informational purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including you existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Additional information available upon request. Past performance is not a guide to future performance. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee as to its accuracy or completeness. This material is published solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or investment product. Opinions and estimates are as of a certain date and subject to change without notice. Wells Fargo Advisors is registered with the U.S. Securities Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Brokerage products and services are offered through Wells Fargo Advisors. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. CAR 0116-05765 2016 Wells Fargo Investment Institute. All rights reserved. Page 6 of 6