What is the Long-Term Relationship Between Oil and Stocks?

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The S&P 500 is up by 1.80% year-to-date. Oil prices have recovered strongly from the recent plunge. In fact, Brent crude closed at $43.10 yesterday after falling below $30 per barrel in January. When it went below $30, experts were predicting $20 or even $10 per barrel. Now that it is over $40 not surprisingly they have become quiet. They may reappear in the media when oil prices $60 some in the future calling for prices to reach $100 soon.

From the beginning of the year until recently oil prices and the stock markets went up and down in tandem. It appeared stock prices were only determined on the price of oil movements. Some experts even starting monitoring the price of oil every day to make their decisions on equities. Though oil and all stocks seemed to be joined at the hip, in reality volatility in oil prices impacting the entire equity market did not make sense.

In general, what is the long-term relationship between oil and stocks? Long-term relationship is important to review as opposed to the short-term since most investors are not investing in equities for 1 month, 3 months, 1 year or even 5 years. So daily oil price movements does not matter to investors who have a long-term focus where it is building a retirement nest egg or saving for college tuition or simply building wealth.

I written before that oil is one of the most volatile commodities in the market. So worrying too much about oil and its impacts on equities day in and day out is not wise.

In an article published this week, Ken Fisher, Founder and Chief Executive of Fisher Investments noted that the long-term relationship between oil and stocks is meaningless. From the article:

MEANINGLESS

Figure 1 (below, click to enlarge) shows monthly returns for both US stocks and oil. The correlation co-efficient is a number between +1 and -1 that shows how much two variables move together.

The higher the number, the more positively correlated they are – zigging together at the same time and to the same degree.

A number close to -1 means they’re negatively correlated – they zigzag the way the myth presumes oil and stocks do. A number close to zero means the two have no relation – one zigs and the other broccolis.

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oil-price-and-stock-market-long term-relationsip

Since 1980, the correlation between oil and US stocks is 0.03. Meaningless – the two aren’t related in the long term at all (by the way, you can do the same thing with oil and UK, German, Japanese, and world stocks, and get the same meaningful lack of correlation).

Now look at the R-squared, which tells us how much of one variable’s movement can be explained by the other. Here, it’s 0 per cent. Said another way, over long periods, anything and everything but oil contributes to the stock market’s movement.

Can oil prices impact certain industries and firms more directly? Sure! Energy firms for a start, particularly if they’re drilling, refining, and/or selling oil or oil products. But overall, oil and stocks aren’t correlated – positively or negatively.

That’s longer term. Over shorter periods, oil and stocks can have short spurts of intense positive or negative correlation. But any two bizarre variables can inexplicably move together (or oppositely) for short spurts. It means nothing.

Source: Oil and stocks seesaw: Fisher’s financial mythbusters, Ken Fisher, Money Observer, April 15, 2016

Oil prices do impact directly firms operating in that particular industry such as producers, refiners, marketers, pipeline operators, equipment providers, etc. But the impact on other industries is indirect and some are affected more than others. In fact, some industries benefit from lower prices and vice versa. So investors are better off to consider many of the other factor that impact stock prices and not purely zoom in on oil price movements to make their long-term investments.

Why Invest in Companies with Lower Intracorporate Pay Gaps

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Executive compensation is out of control globally. Since most of the stock in major corporations are owned by institutions the majority of them support exorbitant pay structures for the management for fear of antagonizing them and potentially lose their business. As a result, many corporations have become the tiny little piggy bank for executives to extract as much wealth as possible during their term in one firm and then move on to another to repeat this process.

A recent research report by index provider MSCI showed that high intracorporate pay gaps leads to lower profit margins. In other words, if the pay gap between the highly paid executives and lower-level workers is high then the company producer lower profits. Lower profit margin eventually lead to lower investment return for shareholders as stock prices move based on the fundamentals of a firm.

From a news report on the MSCI report:

Research by MSCI into pay gaps between executive and rank-and-file workers in companies suggests that those with narrower differences produce better investment returns.

In its report – Income Inequality and the Intracorporate Pay Gap – MSCI notes that immediate performance objectives, such as maintaining dividends, share buybacks and quarterly earnings lead to short-termism, in which labour is reduced to a cost issue to be minimised, rather than be seen as an asset to create long-term value.

For investors, the evidence suggests that the issue could become increasingly important when determining which companies in which to invest; for example, income inequality is estimated to have increased in 63% of countries globally between 1980 to the current decade.

MSCI cites other evidence too, such as higher average profit margins for companies with lower intracorporate pay gaps in the 2009-2014 period, across all sectors except materials.

It said labour productivity was lower for companies with higher intracorporate gaps over the period.

Source: Pay gaps reveal which companies to invest in, Investment Europe, April 7, 2016

Here are the key findings from the MSCI research report:

We observed a relationship between the intracorporate pay gap (the gap between highest paid executives and average worker salary) and country income inequality during the period between 2009 and 2014.

Comparable to economic research cited in this paper suggesting country income inequality tends to slow GDP growth across countries, we observed that between 2009 and 2014 average profit margins were higher for companies with lower intracorporate pay gaps across all sectors except Materials.

We estimate that the Consumer Staples sector had the highest intracorporate pay gap globally; in the US the highest gap was seen in the Consumer Discretionary sector. Both sectors are likely to be highly impacted by movements advocating for adjustments to minimum wages in certain countries.

Labor productivity, measured by sales per employee, was lower for companies with higher intracorporate pay gaps on average during the study period, a finding we noted in nine of ten GICS sectors.

Source:INCOME INEQUALITY AND THE INTRACORPORATE PAY GAP by Samuel Block, April 2016, MSCI

Implications for investors:

  • If a company awards way too much compensation for executives in terms of stocks options and other awards investors may want to be cautious.
  • Investors should also be leery of companies that try to boost stock prices in the short-term with big buybacks.
  • Some hi-tech companies are notorious for making billionaires and millionaires almost overnight when they go public. These firms are known to hand out huge stock options to their executives, friends and family, board members, highly ranked employees like giving out candy. Many retail investors will lose their investment as stocks collapse in a few months or years when early investors such as VC firms and those with stock options cash out. So better to away from these firms.

In summary, high compensation for executives can be justified when a firm makes huge profits and shareholders and employees benefit from the success. However if ordinary workers and investors are soaked dry when those running the firms make out like bandits then it must be condemned. Since no regulations exist to prevent excessive compensation to insiders and retail investors do not have the power to change management, the only thing retail investors can do is avoid such companies by not investing in them.

Number of Mutual Funds by Country

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The mutual funds industry is a big business globally. In the developed countries it is especially large due to the amount of investment capital available. Billions of dollars are run by fund managers on behalf of their investors. Since billions of dollars of fees are at stake, fund companies offer a variety of funds based on many categories such as growth, sector, country, region, dividend, etc. In addition, even within the same fund different classes are offered to differentiate between fee types, amount invested, type of investor, etc.

How many mutual funds exist in countries around the world?

According to the Investment Company Institute, the fund industry’s trade body, there were over 79,000 mutual funds in the world at the end of 2014. The chart below shows this number broken down by country:

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Number of Mutual Funds by COuntry

Notes:

  1. Funds of funds are not included except for France, Italy, and Luxembourg. Data include home-domiciled funds, except for Hong Kong, the Republic of Korea, and New Zealand, which include home- and foreign-domiciled funds.
  2. Data Source: International Investment Funds Association

Source: Investment Company Institute

A few observations:

  • Region-wise Europe has the largest number of followed by the Americas.
  • Korea has the largest number of funds in the world with over 11,000 funds listed.
  • The US has over 7,900 funds. This number is more than the total number of public-firms listed on the US markets.
  • Among the BRICs, Brazil has more than 10 times the number of funds in India.

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Data for the above chart and more (in Excel format)

On the Growth of Mutual Funds in the US

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The mutual funds industry in the US is a multi-trillion dollar industry.At the end of 2014, the industry managed assets of about $16.0 Trillion up from just over $1.0 Trillion in 1990. The growth in assets under management over the years has also led to a fierce competition with a multitude of players entering the market. According to the latest full year data available from Investment Company Institute the total number of mutual funds stood at 7,923 at year-end 2014.

The following chart shows the growth in the number of mutual funds by year:

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Number of Mutual Funds by Year

Note: Data for funds that invest primarily in other mutual funds were excluded from the series.

Source: Investment Company Institute

The growth of the mutual funds business since 1980s is astounding. As the above chart shows, year after year the number of funds consistently increased only dipping slightly after the dot-com crash of 2000 and the global financial crisis of 2008-09. Since the most recent crisis, the number of funds is on an uptrend again.

The number of funds available on the market for investors has increased due to many factors such as the introduction of 401-k type retirement plans, growth in technology, change in investors’ risk appetite, highly successful marketing tactics by the industry, etc. For instance, with a 401-k retirement plan, up until recently most employers offer only mutual funds to participants. Hence employees had no choice but to select one of the handful of funds presented to them. This indirectly “forced” workers in a fund whether they liked it or not. As the number of participants grew each year billions of dollars were channeled to fund companies each month with automatic deductions from employee’s payroll.

As investors poured money into the thousands of mutual funds on the market, the industry created many classes of funds to cater to various types of investors. These classes of funds differ based on many factors like front-end fees charged, back-end fees charged, contingent-deferred sales charge, with sales charges, without sales charges, amount of capital invested by investors, retail investor, institutional investor, etc.

Slicing and dicing the number of limited stocks listed on the markets, the industry had created over 24,200 fund classes for over 7,900 funds. So on an average each fund has three types of fund classes. This 24,200 figure is many times more than the actual number of listed companies on the US market. To put this number into perspective, the total number of US companies traded on the US exchanges at the of end 2014 was just 5,283. So the industry has flooded the market with funds equal to nearly five times the number of companies listed.

Whether the huge number of available funds and the fund class types is beneficial to an investor or the fund companies is open for debate and is beyond the scope of this post.

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Average Tax Rate on Cigarettes by Country

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Cigarettes are one of the most highly taxed products around the world. Equity investments in cigarette companies generally tend to payoff well in the long run as firms in the sector provide solid dividends and stable consistent growth. Successful investors have long observed the unique advantages of making money from cigarette makers. Here is a quote from Warren Buffet:

“I’ll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It’s addictive. And there’s a fantastic brand loyalty.”

In addition to investors, states also benefit tremendously from users of this product due to taxes. In order to discourage smoking, taxes on the stuff is usually high in most countries. In the U.S. states like New York have one of the highest tax rates on cigarettes. High taxation brings in millions of dollars in revenue for the states. Globally taxes on cigarettes varies by country with the UK topping the list and the UAE charging the least with the average tax at just 20%.

The table below shows the average tax rate on cigarette by country:

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Cigaraette Taxation Rate by Country

Source: To protest anti-smoking measures, Indian cigarette companies are… shutting their factories?, FT Alphaville

Among the developed countries, the US has the lowest average tax rate at 42.5%.

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