The Clouded View: Commodities and Stockmarkets in Sync?

We are so accustomed to seeing headlines such as "Markets tumble as oil hits new highs" that we are also prone to believe them. The traditional view is that high crude oil prices feed into inflation, erode profits and hence lower stockmarkets. The traditional view is that gold is an inflationary hedge and hence will rise and fall in tandem with oil. The traditional view is that as both oil and gold are priced in US Dollars then a fall in the currency will lift these two commodity prices so that for the non-dollar world their value remains more or less even. the traditional view has been completely and utterly wrong in recent months.

From its mid-March low of 5416 the FTSE then rallied to 6360 only to recently fall back to this morning's 6045 (-5.5%). In the same period the Dow has gone from 11670 to 13139 and then fell back to a recent low of 12441 (-5.4%). At the same time crude oil has gone from $98.60 to $134.20 a barrel, only to soften to $126.40 (-7.2%). Gold has shown a slightly different trend, peaking at $1032 just when the other three were at their recent lows. However, from mid-May it has shown the same 7% drop as oil. It is this short-term drop in both indices and commodities that I initially found puzzling, then noticed the longer-term trend between oil and the indices. From mid-May the gainers have been Sterling versus the Dollar (up 2.3%) and the Dollar against the Euro (up 2.5%).

So what about this supposedly negative correlation between crude oil and stockmarkets? The FTSE charts show all the signs of it being a commodity-based index and ignoring the broader market. If you look at the FTSE sectors (all traded on IG Index) you will see some very different markets going on. The Mining, Oil and Gas, Oil Equipment and Engineering sectors are all on a high. The rest are either in decline or treading water. The FTSE has some serious players in this area and, on its own, the rise in these sectors looks like stating the obvious. The Dow has less of a commodity weighting yet has shown a similar pattern recently. The thing that I find puzzling is that the rest of the FTSE market sectors seem to be unsure how to respond.

I hate making predictions, but rather just look out for the signals that herald major moves. In this case the key issue is the negative correlation between commodities and stockmarkets. The recent positive correlation must surely break down at some point. To which side is a matter for tipsters. But if inflation fears return, coupled with falling real estate prices, then the other FTSE market sectors are heading south dragging the broader index with it. The commodity sectors will merely cushion the fall. On the upside there seem to be few good signs for the UK economy so that in the short term we may continue to see these resource sectors leading the way. A real unalloyed rally will have to wait until the UK consumer feels wealthier again. There is, of course, a third option, and that is that raw materials and resources will continue to grow in importance and that the FTSE will increasingly resemble something like the Australian market. In this case, the disconnect may be between the FTSE and the Dow. One of these days I'll believe those headlines again.