There is no link between Crude and Stock markets

Many investors have been taken by surprise by the recent weakness in our markets. How can markets fall when the price of crude oil is dropping at record speed? This is the question that’s been making investors scratch their heads lately.

Investors who were breathlessly talking of the black gold at US$175-200 (remember the Goldman report?) Just two months ago have cut their target on crude to US$85-90 a cut of 50% in just two months. How the mighty have fallen? The ever rising shortage scenario for crude oil has been replaced by a sudden glut. Oil prices that once fared up at the slightest whisper now fall despite threats of hurricanes and OPEC output cuts. This drop in crude has turned investors bullish again.

Not many investors followed our suggestion to sell into the rally last month. The same investors who had been projecting the Sensex fall into four digits a few months ago suddenly became reluctant to sell, as the consensus moved around to a large rally in the markets. All eyes were on crude, which had fallen from $147/barrel. As everybody watched crude continued to obliged and fell almost daily down to below $100. But stock markets disappointed everyone with a sharp 10% fall.

This cause and effect belief about falling crude and rising stock markets was built upon the recent bad press about rising process. Commodity price increases were held to be the main culprit for the woes of the global economy and especially India. While it’s true that global (and Indian) problems accelerated over the past few months as commodity prices rose sharply the genesis of the current global woes lies deeper than that. The main drag on global investor sentiment is the problem in the credit markets. These problems stem from underlying economic woes in the US, but have grown into increased risk aversion by investors worldwide.

Coupled with a global slowdown the credit market woes are increasingly putting strain on the balance sheets of the financial industry worldwide. Banks and investors in US, Europe and Asia are facing the challenges of significant write downs. Lehman Merrill Lynch and AIG have already buckled under this pressure. The fear of more shocks remain. The US government has stepped in to address the current liquidity concerns, but this does not resolve the longer term issues of falling home prices, excessive leverage and bad loans. So we can expect these problems to resurface with regular frequency over the next few months. As global financial markets are closely linked, any significant losses in US could have a telling effect on banks and investors in faraway places like Europe, Japan, China and Australia.

As investors book losses on their existing investments, it’s basic human nature that they become less optimistic and more risk averse. Emerging markets are bearing the brunt of this increased global risk aversion. As the slowdown in developed economies threatens to only get worse over the next few months investors appetite for risk is unlikely to come back. Thus, we are seeing a downward spiral in all asset classes including real estate and equity across the globe.

In the first half of the year, commodities not only bucked this downward trend, but prices also accelerated upwards. This was due to two primary reasons: supply constraints and increased investor attention as other asset classes melted down. Suddenly commodities became a hot investment option and people were clamoring for investing ideas in commodities Despite being cautioned that the fundamentals did not justify prices and market internals suggested bubble-like characteristics, investors remained gung-ho on commodities. Direct investment in commodities in India is not possible due to myriad government restrictions so investors piled on to commodity derivatives gold, and international funds that invests in commodities or commodity stock.

It would be unwise to predict that markets will rise because crude prices are falling. One must remember that oil was around US$90 per barrel when the markets had their biggest fall ever, in January 2008. Oil rose above $100 only in April, by when the bear market in India had well and truly set in. Thus, to project and end to the bear market only because oil may below $100 again is flawed reasoning, as it fails take into account the true nature of the current investor worries worldwide. It would be premature for domestic investors to look at the falling crude oil prices and bet on rising equity prices. Look instead at credit markets worldwide. Whenever those stabilize, investors will set out to look for bargains in emerging markets, until then brace your self for a rough ride.