Oil is not going back to $100 for a very long time

Outlook:

We often note that supposed correlations of one financial asset to another are wonky and unreliable, like the euro always rising when the S&P falls or even the CAD being joined at the hip to oil. Most of these relationships are false and fleeting. The only one with lasting power is the Nikkei and the yen.

But there is an exception to the rule of being skeptical about correlations, and that’s when a couple of markets get hysterical at the same time. That’s when the supposed correlations do poke their heads up and take over, probably because in the absence of decent supply-demand information, you might as well go with market lore. The supposed correlations come true out of self-fulfilling prophecy. Academics, including those at central banks, are fine-tuned to trying to read this kind of contagion.

The link between falling oil prices and stock market indices is the one in front of us right now. That WSJ headlines are hilarious—on Friday day equity indices are down because of oil prices and today they are up “as oil falls.” Bottom line—there is no necessary and sufficient linkage between the two. Analysts point out the FTSE 100 is more heavily weighted to Big Oil than other indices and so there’s a case to be made there. But overnight Brent hit the lowest low since 2004 and so far today the FTSE 100 is up 0.84%.

So be careful what you read about correlations. As we wrote last week, oil is not going back to $100 for a very long time. It might not even be going back to $65. Anyone who doesn’t see this is not paying at-tention to the supply situation. That doesn’t mean a one-way street but it does mean we should be skepti-cal about mini-rallies of a dollar or two, not to mention supposed spill-over effects to other markets. One place we can be sure the oil price drop will have a direct and measurable effect is oil-producing countries which without oil would be failed countries. Venezuela is increasingly on the verge of eco-nomic collapse.

A better case in point: Azerbaijan devalued the manat for a second time this year today, by 32.3% (following 40% last Aug) because of collapsing oil prices, making it what the FT names “the world’s worst-performing currency this year.” The new regime is supposed to be a float. Reserves are down to $6.8 billion from $13.8 billion at the beginning of the year and the central bank is already tapping the sovereign wealth fund ($35 billion). Norway, as possessor of the largest sovereign wealth fund based on oil revenues, manages far better. As for other producers, it may be touch-and-go in weak-er sovereigns (Nigeria), less iffy in stronger ones (Mexico) but surely a big theme next year.

One of the most interesting facts we have seen a long while comes from the BOA Merrill Lynch month-ly fund managers’ survey (taken Dec. 4-10 and released Dec. 15) reported by Market News. Managers are less overweight European equities (55% in Dec from 58% in Nov). “In contrast, U.S. equity alloca-tion fell to an eight-year low, with a net 19% of portfolio managers underweight U.S. stocks, ver-sus a net 6% underweight in November and a net 10% underweight in October.”

Huh? We must presume managers re-allocate according to where they see corporate earnings rising the most and thus equity prices following. But for the allocation to the US to fall to 19% underweight, an 8-year low, is surely far too big. If the Fed hiking rates is behind it, it’s an overreaction. If it’s the too-strong dollar behind it, it’s an overreaction. It’s a stunning number. At a guess, it won’t last.

For the FX market today and the rest of the week, we despair of seeing the “inevitable” dollar rally pok-ing its head above the choppy waves. It will probably happen, but not this week. You should probably consider closing your book for the year. Lot of things can still happen, but not with reliable outcomes.