We recently wrote about the dangers that charts can pose to our pattern-seeking brains.  Charts can be useful tools, efficiently summarizing a great deal of data into a single picture.  Other times the intuition behind the chart itself is flawed.  This is often the case when analysts try to tell a story using the ratio of two price series, when in the fact the two series are not related.

One of the best providers of (free and subscription) charts are the guys at Bespoke Investment Group.  (Who by the way make frequent appearances in our daily linkfests.)  However they may have gone one chart too far in a recent case.  Unfortunately the graph in question is a part of their premium service, but the results were described in a recent Bloomberg article.

In it they plot the ratio of the S&P 500 to the price of crude oil.  From the Bloomberg article:

The benchmark for American equity traded at an average of 21 times oil between 1986 and 1997, Bespoke said in a research note. Should the price of oil remain at its current level, the S&P 500 would have to climb to 1,700 to restore the ratio.

“Unless you think there’s some sort of secular shift in the relationship, oil supplies declining or something, then you would expect the historical relationship to return to normal,” Paul Hickey, an analyst and co-founder of Harrison, New York- based Bespoke, which manages money for wealthy investors and provides financial research to institutions, said in an interview.

Lets leave aside the potentially huge moves this analysis implies for either the stock market or the price of crude oil.  Let’s think more broadly about this ratio.  Below you can find our version of the chart.  The data does not include the entire period Bespoke covers, but you get the general idea.

A quick glance at the chart shows anything but a stable relationship.  Trying to make predictions (short or long term) for either crude oil or stock market seems like a mug’s game.  There is simply too much variability.  For kicks, let’s replace oil with everybody’s other favorite commodity, gold, to see if we get a better result.

Again the variability is such that there is little in this chart that should change the way any one thinks about either the price of gold or the S&P 500.  Back to oil.

We do not know of any economic theory that posits a stable relationship between the price of commodity (oil) and that of equities. Remember that equities are (presumably) priced on the discounted value of their future free cash flows.  (We don’t remember a variable “O” in the dividend discount model.)  The price of oil is driven by the current supply and demand situation.  Given the dynamic nature of the economy why would one expect this ratio to remain relatively stable over decades?

On the contrary there are any number of reasons to believe that this relationship is not stable.  For instance the changing energy intensity of economic production should affect this ratio.  As should the changing sectoral composition of the S&P 500.  To say nothing of the changing dynamics (including technology) of the global oil industry.  Let’s not forget about the role of interest rates either.  In short, there any number of dynamics at play that should work against there being a stable relationship between the price of oil and stocks.

The S&P 500 might soar (or fall) and the price of oil might fall (or soar) but it will not be because the relationship between the two got out of whack.  The underlying dynamics of each market will do that all by themselves.

The fact of the matter is that these type of charts are generated every day.  Before drawing any sort of conclusion you need to ask yourself whether there is any sort of financial or economic intuition behind the posited relationship.  If not, there is nothing to see here, move along.

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