What Do Falling Oil Prices Mean For The Stock Market?

Posted by Don Garman on December 29, 2014

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Looking Good In The New Year

Over the past few weeks, a number of people have asked me what the stunning drop in oil prices means for the stock market.

Answer: It’s unambiguously good for our portfolios and for most of America.

Falling oil prices are tantamount to a huge stimulus package for the economy – like a giant tax cut. According to James Furman, chairman of the White House Council of Economic Advisers, every $8 to $10 drop in oil prices adds one-tenth of 1% to GDP.

The drop in oil is already putting money in the pockets of millions of people in the form of lower gas prices. The average American will save more than $1,000 per year from gas prices that are now below $3 per gallon. That will give consumers more money for discretionary spending in 2015, which will be bullish for the market.

Why The Sudden Drop In Oil?

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It’s hard to fathom how quickly crude prices have fallen since mid-year. If the stock market had plummeted 50% in six months, people would be hiding under their beds.

In our view, the price decline in oil is due to oversupply and geopolitical tensions around the world. It’s not an indication that the global economy is dramatically slowing. In fact, U.S. GDP for the third quarter was revised upward to 5% last week, the highest annual growth rate in 11 years.

The oil glut is the result of too much production by OPEC nations and other oil-producing countries, as well as the significant increase in U.S. oil and natural gas production over the past five years.

Because oil prices have crashed, most earnings estimates haven’t been adjusted accordingly. We just saw our first upward adjustments in the past week, and we expect to see more revisions in the coming weeks.

Optimistic For 2015

The earnings recalibration that will unfold has changed our view of 2015. We’ve gone from cautiously optimistic to optimistic.

As a result, we’ll be looking to buy value stocks at 12 to 13 times earnings in 2015, and avoid those at 20 times earnings, which is where many U.S. large-cap and mid-tier stocks are now.

In particular, that means we’ll be focusing on two types of equities that were out of favor in 2014 – small cap stocks and large cap European stocks.

With the dollar rising, European large cap stocks will be more attractive again after five years of underperformance. The strengthening dollar makes U.S. goods more expensive abroad, while European products become more affordable. Why buy Coke at 20 times earnings when you can buy Nestle at nine times earnings?

Small cap stocks are also more attractive due to the fall in oil prices. Consumers will have more discretionary spending, and that typically favors small cap companies that are primarily domiciled in the U.S and benefit from a stronger U.S. economy.

The Bottom Line

All in all, I like our strategy going into next year. Our current portfolios have performed well as oil prices have plummeted.

If oil prices remain low in 2015, as now appears to be the case, it could be a Happy New Year for equities.

Topics: Market Outlook

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