What the Tsunami Will Do to Equities and Oil

Experience teaches that market behavior on a given day says nothing about trends

The markets can be hard to comprehend and events at the end of last week show why. On Friday Japan experienced the most powerful earthquake in its recorded history, followed immediately by enormously destructive tsunamis. Over in Libya, the war between the rebels and forces loyal to Muammar Gadhafi escalated, and in Saudi Arabia, another "day of rage" was declared by would-be reformers. And the result of all this? Oil prices fell, the yen strengthened and Wall Street stocks gained ground.

How can that be? And even more interestingly to investors, what is the formula connecting share prices, oil prices and the dollar?

The behavior of oil prices is the easiest to explain. They retreated from peak heights because of three factors.

One: The quake and tsunami damaged Japan's refineries, which will diminish demand for crude. Japan is the world's third-biggest consumer of oil, and having none of its own, imports all its needs.

Two: The dollar strengthened. Since oil prices are always quoted in dollars, their price in dollars fell.

Three: The last day of rage in Saudi Arabia fizzled out, allaying fears about the supply of oil from there - Saudi Arabia is the world's second-biggest oil producer after Russia.

Fine. Why the yen's appreciation? Traders explain that Japanese financial institutions such as insurance companies will have to stock up on yen to pay out compensation. They'll do so by selling financial assets denominated in other currencies - such as U.S. treasuries. Nifty forex traders, anticipating an imminent spike in demand for yen, are preparing.

Why Wall Street stocks gained ground late Friday is the hardest of all to explain. Beforehand stocks were in retreat everywhere. Maybe American investors felt the markets had overshot, which tends to happen after a disaster.

In any case, all three - the yen, oil and U.S. equities - are just the events of one afternoon. If experience teaches anything, it's that market behavior on a given day says nothing about trends, and on Friday the markets were also evincing great confusion and wild swings.

The lessons of the previous quake

History can be useful. The last big quake in Japan, in January 1995, devastated the city of Kobe. More than 6,000 people lost their lives and damages reached $102 billion, roughly the scale this time around, based on initial estimates. Japanese stocks lost 7% on the first trading day after the Kobe temblor, and continued to trend downward for six months. In July share prices started to rally and by year-end, stocks had regained their lost ground.

Recent history also hints at correlations between equities and oil. Comparing the price of crude to U.S. benchmarks shows that both have been tightly correlated since the economic recovery began in March 2009. Oil crept up, but that didn't hinder stocks. On the contrary: The rising price of oil was indicative of economic recovery, and shares rose too.

But three months ago that correlation began to weaken and a few weeks ago, it strongly reversed. Every time oil climbs some more, U.S. share prices drop. The correlation today is minus 0.7%, not far from minus 1, which means complete negative correlation.

The breaking point was $80 per barrel, and when oil passed $100, the correlation turned absolutely negative. At current levels, the equation is simple: When oil climbs stocks drop, and vice versa.

Terror of oil shock

Why is this happening? Apparently, the answer is fear of an oil shock. Most economists agree that $100 per barrel is bad for the U.S. economy and any economy that imports oil, and if it's bad for the economy, stocks will drop.

What has the dollar to do with this? Even simpler. Oil has inherent value that depends on genuine supply and demand, which have nothing to do with the nominal price at which the commodity is quoted. Most oil isn't produced in the United States, and trade can take place in other currencies such as the ruble and the Saudi riyal.

But oil in world markets is quoted in dollars. Therefore, every time the dollar weakens, the price of oil rises and vice versa. Based on current trends, for Western stocks to continue to rise, and Tel Aviv stocks too, oil had better stop rising and the dollar had better not weaken too much.