Oil’s down…why isn’t the market up more?

If someone told you in mid-July that crude oil would drop from nearly $147 per barrel to $105 in less than two months, you would probably expect that the US stock market would soar. Of course, stocks have rallied from those summertime lows, but to quote my friend, “if oil is down by over 20%, then why isn’t the market up more than 3-4%?”

This is an excellent question -- especially in light of the fact that it appeared that the stock market was moving tick for tick with oil, only in the wrong direction, and that news outlets like CNBC were blazing graphics like “America’s oil crisis,” which seemed to link the rotten stock market directly to the price of crude oil. While it is clear that consumers and businesses alike were under pressure from ever-escalating prices at the pumps, to some extent, the rise in energy was a complete head fake for many investors.

Consider that on Friday July 11th, crude oil closed at $145.08, the S&P 500 settled at 1239 down 15.59% for the year and the Dow Jones Industrial Average was at 11,100, down 16.32% for the year. Flash forward to yesterday…we started the day with crude oil down big on the “disaster averted” news of Hurricane Gustav. Stocks came barreling out of the gates sporting nifty gains, but the rally fizzled and stocks actually fell on the day. That means that with crude down approximately 25% from the highs, large US stocks have only added 3-4%.

Although there is great relief that oil has staged a major retreat, the oil story may have taken investors’ eyes off of the larger issue that is still driving the economy and markets: the two-headed monster called the housing and credit crisis. Unfortunately, the beast continues to wreak havoc and we have yet to see any real signs of significant improvement. Oh sure, the housing numbers were a touch better last month, but we need more than one month of data to be convinced that we have turned a corner. Until that occurs, tight credit conditions persist, as evidenced by widening spreads last week.

Some had hoped that a Fed/Treasury intervention into Fannie Mae and Freddie Mac would help ease the credit system. To that point, I ask the following: if Fannie and Freddie were to get bailed out by Uncle Sam (which is to say, you and me) and the Fed were to assume trillions of dollars on to the national balance sheet, who would be stepping up to the plate to lend in that environment?

Many past financial crises were catalyzed by a boom and bust in real estate, which then led to a loss in the value of the country’s currency and culminated with the nationalization/socialization of bad debt. While our current process may have been exacerbated by rising commodity prices, without an end to the housing contraction, the monster is still out there and falling oil prices will not be able to conquer it single-handedly. What will eventually do the job is an unwinding of the excesses of the previous period. Until that time, my guess is that the rise in stocks is an emotional bear market rally that may ultimately disappoint investors.