Back to the future - echoes from the last oil shock

By Tom Stevenson, 3 July 2008

In the week in which many stock markets completed their worst first half performance for years, Tom Stevenson looks back to the lessons from previous bear markets. The first half of 2008 has been one of the worst ever for stock market investors. The FTSE 100 fell 12.9% between January and June, its worst showing in those months since 1994⁽¹⁾. Germany’s Dax ended June 20.4% lower than it started the year while the CAC 40 in Paris was down 21.0%. Asia fared as badly or worse, with Hong Kong and India down 21% and 34% respectively⁽²⁾.

In the US, the Dow dropped 14.4% in the first half of 2008. After the March-to-May rally fizzled out, the Dow experienced its worst June performance since 1930⁽³⁾, down 10.2% in a single month.

You do not need to look hard for a cause. For the best part of a year, equity markets held onto the illusion that the US financial and housing market crisis could be contained. Bulls argued that the problem could be solved by the familiar monetary stimulus of lower interest rates, while continuing growth in the rest of the world would keep the show on the road. The S&P 500 was actually higher in May than last August, despite the hurricane blowing through the global economy.

What the optimists didn’t fully understand was that the traditional cheap money antidote was a shot in the arm that most of the world did not need. The mismatch between overheating growth in the developing world and lower interest rates resulted in rising inflation and, most importantly, a soaring oil price.

Oil price reaches new highs

The world’s most important commodity is uniquely able to derail the global economy, and with it corporate profitability, because it is both a crucial input to many production processes and vital as a consumer good. Having risen from $96 a barrel at the start of the year to a new record of over $140, the price of crude is finally biting.

The result, at least in the short term, is that most unholy of economic combinations, slowing growth and rising prices. Stagflation. As Lehman Brothers put it in a note to clients this week, “the one combination of factors that could have undermined our positive outlook for stocks in 2008 has undermined it. While we might argue that the current environment is a world away from that which prevailed in 1974 or indeed 1978, market prices tell a different story.”⁽⁴⁾ 

Lessons from history

So if we have indeed travelled back to the future, to a re-run of one of the darkest periods of recent economic history, what lessons can investors learn?

One is that stock market averages are just that – averages. Look behind the headlines and there are huge variations in performance. While some housebuilders in the UK have lost 80% or more of their stock market value since their peak early last year, the MSCI Latin America emerging markets index, buoyed by Brazil’s commodity-led economy, has risen 32% over roughly the same period. As in the 1970s, and unlike during the 1980s and 1990s when just being there was what counted, asset allocation, or being in the right place at the right time, is key.

The second lesson is that the big pendulum swings in markets since 2000 are not that unusual. Extended periods in which markets experience a roller-coaster ride but end up no higher than they started are as common as the steady appreciation interspersed with relatively short setbacks that investors learned to expect in the long bull run from 1982 to 2000.

On 2 December 1968, the S&P 500 closed at 108.1 but nearly 14 years later, on 12 August 1982, the index traded at 102.4. The fact that the FTSE 100 ended June 2008 4% below the level at which it traded in June 1998 is unlikely to cheer anyone up but it is not sufficient evidence that equities are no longer the best place for long term savings.

Between 1968 and 1982, moreover, there were tremendous opportunities for investors. Between July 1970 and January 1973, for example, the S&P 500 rose by 66%. The period from October 1974 to November 1980 saw the market rise by 120%.

A third lesson is that while the world is spending more on oil (as a proportion of GDP) than at any point since the second oil shock of 1979, equities are as cheap (measured against risk-free government bonds) as they have been at any point since that time⁽⁵⁾. As a result, it is not unreasonable to look at the trajectory of share prices around that period for guidance as to what we might expect from here.

Equities held up initially as the price of oil soared in 1979 but then fell back sharply as higher crude took its toll on the wider economy. Between April 1981 and March 1982, stocks fell by 17%, according to Lehman Brothers. Thereafter, however, once growth resumed stocks took off. In the 14 months after August 1982, the S&P 500 soared by 69%.

History does not repeat itself, but it often rhymes. In 1982, as today, shares had been increasingly out of favour for an extended period of time and a soaring oil price had triggered a savage recession. The market bounce that followed was dramatic but many investors, wrapped up in the prevailing feeling of revulsion towards the stock market, will have missed it.

The great unknown is how far into this cycle we currently are. As Anthony Bolton wrote here last week, it still feels as if things could get worse before they improve. After a ghastly six months in the market, and a ten year period in which shares have moved sideways overall, it is hard to be more optimistic – just as it was in the dark days of 1982 when enthusiasm for stocks would have been laughable….but right.

Past Performance is not a guide to what might happen in the future. Investments in small and emerging markets can be more volatile than other overseas markets. For funds that invest in overseas markets, changes in currency exchange rates may affect the value of your investment. The value of investments can go down as well as up, so you may get back less than you invested.

^Sources:

^{(1) Source: Financial Times, 1 July 2008
(2) Source: All market and stock performance data - Datastream
(3) Source: BusinessWeek, 1 July 2008
(4) Source: Lehman Brothers, Global Strategy Weekly, 27 June 2008
(5) Lehman Brothers, Global Strategy Weekly, 27 June 2008} 

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