Can oil prices predict the Sensex level?

Wed, 30 Mar Pre-Open

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Commodities is a hot subject when it comes to future predictions these days. Several of them including gold, silver and more importantly crude oil are expected to determine the fate of investors. And why not? Famous investors like Jim Rogers and Mark Mobius have made no bones about the fact that they favour commodities over other asset classes for the long term.

The underlying logic is also enduring. The risks from derivative contracts, capital flight and sudden changes of sentiments amongst FIIs will continue to exist. However, these reasons do not outweigh a positive long-term picture for commodities in view of the growth that lies ahead for emerging markets. Agreed, commodity prices could take a hit in the near term on account of weakness in the developed economies. However, over the long term, commodities can head nowhere but northwards. This is as countries like China and India try to bring millions of consumers out of poverty. The latter can, thus more than make up for the fall in demand from developed nations.

But an interesting prophecy that we recently came across seemed to top all these. It claimed to establish a link between the movement of oil prices and the benchmark stock market indices! An article in Pragmatic Capitalism, attempts to explain a 10-year indication that crude oil prices give for the stock market. It suggests that stock markets have remained flat for a decade when crude prices have moved sideways. However, rise in crude prices have been followed by a decade of bull markets. It also accords the rise in US stock markets over the past decade to the fact that prices of crude oil have risen from US$ 11 per barrel in 1998 to above US$ 100 per barrel now. Notwithstanding, volatility in stock markets in the interim, the article claims that the long term trend of the indices matches that of crude.

The only caveat here is that this principle works best when left to market forces of demand and supply. However, when governmental or quasi-government bodies artificially control prices, the trend may differ. It cites examples of the Arab Oil Embargo in 1973, the Iranian revolution in 1979, the oil price crash of 1986 and the 1990 Iraq invasion. In each of these instances, the crude prices were driven by unnatural factors. Hence the disparity with stock market performances.

While this theory does make an interesting read, we believe that predicting stock markets is not as easy. For if that were to be the case, the energy analysts would have been the richest investors today. Crude certainly is one of the most important commodities traded globally. A lot also rests on the availability of the commodity for the economic prosperity of nations. However, neither the oil producing nations nor the energy analysts have had much luck when it comes to its correlation with stocks.

Predicting the index levels has in fact never been of much use to the long term investor. For not every component of the index is an equal wealth creator. Hence the opportunity lies in identifying solid stocks at compelling valuations. Irrespective of the crude prices and Sensex levels, these can help multiply your returns.