Why is the S&P 500 so resilient? Brent oil prices have breached the $100 level, but the index has only fallen about -7% on a peak-to-trough basis. The apparent divergence has led to a number of Street economists and strategists to call for a deeper pullback based on rising recession risk.
From a top-down macro perspective, here are some key differences between the current surge in oil prices and past stock market behaviour based on commonly cited recent oil spike episodes. Most recently, the 12-Day War saw a brief spike in oil price, but the 52-week rate of change was negative, and the S&P 500 shrugged it off. When Russia invaded Ukraine in February 2022, the 52-week rate of change in oil prices was already elevated. In fact, the real surge in oil occurred about a year prior to the invasion. The S&P 500 was already tracing out a top prior to the onset of the war by breaching its 40-week MA before the invasion. By contrast, the S&P 500 only began a test of its 40 dma last week, three weeks after the onset of hostilities.
While I have some sympathy for the calls of equity market weakness and rising recession risk, here are some other reasons why the S&P 500 has been so resilient.
An Internal Rotation
The main reason for the relative resilience of the S&P 500 is the continued bifurcated nature of the market and a “lucky” diversification of the S&P 500 portfolio into strong stocks.
Remember how I highlighted the appearance of the Hindenburg Omen and the NYSE High-Low Logic Index in February? Elevated High-Low Logic Index readings are indications of a split market, and these conditions have often led to pullbacks.
Prior to the onset of Gulf War III, market leadership was dominated by cyclical stocks (red dotted line) while megcap growth lagged. The war sparked a rapid rotation away from cyclicals back to growth.
This matters because non-energy cyclicals made up only about 10% of S&P 500 index weight. Sure, they fell as investors abandoned the cyclical growth theme, but large-cap growth, consisting of technology, communication services, and Amazon and Tesla in the consumer discretionary sector makes up about half of S&P 500 index weight.
The war also set off a stampede for U.S. assets for their safe-haven status. Asia, followed by Europe, is more sensitive to higher energy prices, while the U.S. is a net energy exporter. The Sell America trade quickly turned into Buy America. To be sure, the USD had already bottomed in late January and started to rise in February, and Treasuries outperformed non-U.S. developed market sovereign bonds in the same time frame. The most dramatic effect of the U.S.-Israel attack on Iran was the sudden reversal in relative performance of non-U.S. to U.S. stocks (bottom panel).
Simply put, the S&P 500 was resilient because equity market weakness was evident elsewhere. Cyclicals lagged, but they were only a small weight in the index. Equity weakness was also evident in non-U.S. markets, but their returns are not part of the S&P 500. In the meantime, U.S. large-cap growth regained its leadership status as relative breadth indicators improved (bottom two panels).
The Market Outlook
Having explained the reasoning behind the relative resilience of the S&P 500, what’s the prognosis?
It’s all about the earnings outlook. Strategists have highlighted the remarkable improvement in earnings estimates despite three weeks of oil shock.
An analysis of earnings growth dynamics shows that much of the improvement in expected earnings growth comes from the technology sector. Other sectors showing positive expected EPS growth improvement are materials from the mining industry because of higher commodity prices, and utilities, which is mainly attributable to increased data centre electrical demand.
I believe top-down analysts who focus on the evolution of bottom-up earnings estimates during a macro shock are looking at a lagging indicator. Top-down strategists have models that can forecast the effects of a macro shock, but bottom-up company analysts tend to be unwilling to adjust their estimates until they see some clarity on the economic environment. Imagine that you are a company analyst covering an economically sensitive industry like restaurants. What do you say if a client asks about the earnings effects of a $100 oil price?
In the words of Fed Chair Jerome Powell at the latest post-FOMC press conference, “We just don’t know”. When questioned about the effects of the war, Powell responded, “The implications of events in the Middle East for the U.S. economy are uncertain. In the near term, higher energy prices will push up overall inflation, but it is too soon to know the scope and duration of the potential effects on the economy.”
Much depends on the duration of the war. Supply chain effects are already set into motion. It isn’t just oil, but natural gas, aluminum, urea and fertilizers, refineries, copper, and a host of other commodities that are affected by the Iranian blockade of the Strait of Hormuz. Once production is curtailed, it takes weeks to months to restart and normalize output, depending on the nature of the plant. Already, QatarEnergy declared that it may have to declare force majeure on long-term LNG contracts for up to five years. An extended Middle East war sparks a series of 2022-style earnings downgrades in 2026.
The U.S. faces a number of key calendar deadlines in the coming days that are not negotiable for its economy. By mid-April, corn and soybean plantings need to be in the ground, and higher fertilizer prices will reduce the level of plantings and leave the U.S. with a shortfall for the year.
The USDA will publish its prospective planting report on March 31 that measures farmer intentions. The report is a key reference document for the market to estimate global food supply for the year. The FAO Food Price Index will be published on April 3, which incorporates the post Strait of Hormuz blockage effects, and will be a key indicator for the UN whether to declare a global food emergency.
Equally important is the reduced level of methanol production and inventory in India, which is feedstock for generic pharmaceuticals produced in India. If the war continues, inventories could be depleted by late May, which restricts the production of key drugs like paracetamol, ibuprofen, metformin and antibiotics. For a perspective on the supply chain difficulties in fertilizer, India formally asked China for emergency supplies of urea on March 12 in order to maintain its fertilizer production. China responded on March 16 with a ban on fertilizer and phosphate exports on March 16, four days later.
These key deadlines underscore the knock-on effects of supply chain bottlenecks of the war and the Strait of Hormuz blockade. Economic effects are going to become very real in the coming weeks. While individual deadlines matter, the more worrisome effect of cumulative and overlapping shocks to the energy, food and pharmaceutical supply chains could dent economic growth.
In conclusion, I explain the remarkable resilience of the S&P 500 in the face of an oil shock by index composition. Cyclical stocks within the index have skidded, but they only comprise about 10% of index weight, while large-cap growth with about 50% have taken the leadership mantle. The S&P 500 also benefited from rotation from non-U.S. to U.S. stocks for their safe-haven status.
Longer term, much depends on the duration of the war. Supply chain effects are already set into motion. It isn’t just oil, but natural gas, aluminum, urea and fertilizers, refineries, copper, and a host of other commodities that are affected by the Iranian blockade of the Strait of Hormuz. Once production is curtailed, it takes weeks to months to restart and normalize output, depending on the nature of the plant. An extended Middle East war sparks a series of 2022-style earnings downgrades in 2026, which would pose a headwind for the stock market.
