The Stock Market & Oil Prices: A Dangerous Duo

 investor sentimentIt really is the perfect environment for higher oil prices, which is both good and bad for the U.S. economy. Higher oil prices reflect a better economic outlook, as speculators bet on better gross domestic product (GDP) growth in the U.S. market. This translates right into the stock market. But, as we all know, higher oil prices also mean higher gasoline prices…and this is inflationary and cuts into consumers’ incomes.

There is a slight premium in oil prices today related to tensions with Iran. It’s not a big premium, but my best guess is that it might be around $5.00 a barrel. The stock market certainly isn’t worried about higher oil prices right now; equities have too much support from the Federal Reserve to be concerned. Stock market investors are buying because of unprecedented monetary stability and the hope for better corporate visibility. Oil prices are going up because of demand and supply, coupled with some speculative fervor.

The big news in the stock market continues to be with large-caps, especially within the technology sector. As a group, I think technology is a little ahead of itself. Things just aren’t that rosy yet. But, with stock market valuations still very fair, positive investor sentiment is behind the big push. Institutional investors (like individuals) don’t have much choice out there in the investment landscape. Bonds and cash don’t pay anything and the real estate market is a bigger gamble than dividend payments.

Chatter in the investment world is toying with the possibility of oil prices heading to around $125.00 a barrel in the not-too-distant future. (See Why Oil Prices, Gold and Silver Are Looking Good Again.) Within this equation is an equal amount of improving expectations for the U.S. economy, but also supply concerns related to geopolitical activities. Wall Street is quietly raising its oil price forecasts and Street analysts aren’t yet predicting how this will affect the Main Street economy. Four dollars for a gallon of gas seems like the new norm and gasoline prices could go higher yet throughout the summer.

While the actions of the Federal Reserve have been proven to help the stock market and commodities over the near term, policymakers need to be very careful not to fan the flames of inflation. Price inflation would be helpful in the real estate market, but not elsewhere now. We could have a big problem on our hands in a few years if the U.S. M2 money supply doesn’t get under control. Central bankers and governments love to print money, because it’s easier to grow through inflation than it is to belt-tighten. I’m not yet worried in today’s economy about price inflation, but it is out there and it has real potential to keep longer-term growth rates subdued.

The near-term trading action in the stock market and commodities is mostly positive. For quite a while now, oil prices have been trading commensurate with the stock market as a call on economic growth in the U.S. economy. This may last for this year, but I wouldn’t be surprised at all if the next recession were caused by higher oil prices. It’s the perfect catalyst for next year’s slowdown.