Oil Scare Past, Inflation Watchers Stay Busy

Even when crude was rising, inflation didn't rear its ugly head.
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It had to happen. Greed-crazed buyers paid no attention to the fundamentals of their market and pushed prices up despite all manner of technical warnings. Volatility surged as prices tripled in a year's time. Headline-grabbing politicians materialized on cue. Finally, prices plunged more than 20% in a few days.

We are, of course, talking about the crude oil market. The word "fundamentals" should have been your tip-off. At least we didn't have to listen to

Sen. Charles Schumer

(D., NY) demand the creation of a Strategic NASDAQ/Internet Trust (SNIT).

The price of crude oil and its effect on financial markets have been discussed several times in this column: We

opined in October that the price of crude would not be inflationary if the


remained tight, which has been the case. We also

suggested that the underperformance of oil stocks would end, oddly enough, when both the price of crude oil and its backwardation, the discount of forward-month futures to spot-month futures, started to fall.

While it isn't that surprising that rising oil prices didn't portend higher inflation, there are other factors, such as the strength of the dollar and risk premium in equities against bonds, showing a benign inflationary outlook on the horizon.

And whither transportation stocks, whose 10-month bear market was only in part due to higher fuel costs? Now that oil prices have broken, at least for the intermediate term, what should we expect?

First, the oil stocks have continued to lag the

S&P 500

over the past few weeks even though value stocks have performed relatively well since the beginning of March. This should not be too surprising; past breaks in backwardation have taken six to nine months to produce the general price trough required for a strong-buy signal on the group.


Dow Jones Transportation Average

presents a more interesting story. By early March 2000, the Transports had fallen below their October 1998 low, a buy signal if ever we'd seen one based on the March 10 value of 2365; the index is at 2828 at the time of this writing, an increase of nearly 19.5% in only six weeks.

The relative performance of the Transports bottomed on Feb. 25, while the fuel price index -- a weighted average of 60% gasoline, 30% diesel fuel, and 10% jet fuel -- reached its peak on March 7. Some of the market unpleasantness of the past week was attributed to sector rotation, the selling of the


issues against the purchase of those suddenly lovable Old Economy stocks. The timing of the Transports' rise suggests differently: This index correctly anticipated a decline in its components' most important variable cost.

Inflate This: The Market's Not Worried
Although oil prices rose, other key inflation warning signals are showing a safe short term.

Source: Bloomberg

A Matter of Interest

The knee-jerk reaction associating higher crude oil prices with increased inflation has been debunked yet one more time. Get used to it: Next time oil prices rise, we'll have to slay this dragon again. Inflation is a difficult concept to measure correctly with the

consumer price index as this index includes a heavy energy component. Moreover, the CPI assumes no rational economic behavior such as price elasticity of demand, the quaint notion that demand falls when price rises. Better, market-derived measures of inflation include the strength of the dollar, the slope of the yield curve, and the risk premium in equities relative to

bonds .

The logic for each of these being a good inflation indicator is compelling. If inflation is a monetary phenomenon, then nothing should flash a warning sign of excess dollar creation faster than the currency market. Similarly, an increasingly positive yield curve spread indicates bond investors are demanding a higher yield to compensate for inflation risk as the central bank drives short rates lower. The risk premium for equities, defined here as the P/E of the S&P 500 less the reciprocal of the 10-year Treasury note yield, should shrink if investors believe higher inflation is imminent.

None of these phenomena have been present so far in 2000, either before or after the crude oil price peak. The dollar index has been quiet, almost suspiciously so, in the presence of higher U.S. interest rates. The Treasury yield

curve has inverted, which is always a sign of tighter monetary policy and declining inflationary expectations. Finally, the premium of equities to Treasury notes, which had been declining from mid-January to late-February, has been increasing. The effects of crude oil price movements, both higher and lower, are difficult to discern in any of these measures.

Transports Get Movin'
The Dow Jones Transportation Index is up almost 20% over the past six weeks.

Source: Bloomberg

From a macroeconomic viewpoint, there's no bad news associated with lower oil prices. They act as a tax cut for the economy, something Congress does not wish to bestow upon the rich. This little bit of fiscal stimulus will offset higher short-term interest rates, just as both the yield curve inversion and the stronger stock market have done.

Conclusion? We've weathered the higher oil price storm quite nicely. Bring on the next crisis, please.

Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites your feedback at