Crude Oil vs The All Ordinaries… Who Will Win?

Correlation isn't the same thing as causation. Our year nine maths teacher taught us that.

"Every single person," he said, illustrating his point, "who drinks milk...dies. There's a perfect correlation between drinking milk and kicking the bucket."

A couple of inattentive students looked worried. What our maths teacher meant, of course, was that milk isn't a significant cause of bucket-kicking. Unless you happen to be a particularly uncooperative cow.

But whether you're bovine or human, here's a correlation that should have a bit of meaning for you. There's some causation here. Take a look a look at the graph below, Crude Oil vs The All Ordinaries.

Yesterday we looked at the Dow Jones version. The All Ordinaries has fallen in much the same way as crude oil has risen. But since oil corrected, the bounce in shares hasn't taken off yet.

There are a couple of reasons that might be the case. The oil price might not be the cause of share price movements. Or a bounce in shares might be ahead.

We think it's somewhere in between. Crude oil certainly isn't the only cause of the downward slope in the All Ordinaries this year. Worries about inflation (more on that below) and earnings are right up there. But the oil price has been a bigger worry for shareholders.

Why? Well, the heart of Australia's economy runs on energy. The two big sectors in the market are financials and resources.

What happens to a resource company when you take energy away from it?

That. That sorry chart is the tale of nickel miner Minara Resources (ASX:MRE). It's been unable to run operations at full capacity since Apache Energy's gas plant at Varanus Island blew up. Nickel production will be around 4,000 tonnes lower at Minara this year. That's causation.

Its P/E ratio has tumbled from over 11 to under 4. The market would rather chew on glass than look at this company now.

But isn't this what's happening in the overall market itself ? Just on a slower time scale. An invisible hand is slowing removing oil from easy access. Energy is contracting. If oil prices rise in the long term, the mining and manufacturing sectors will eventually feel a general production slump.

We reckon that's the major reason the market was selling under 5000 points earlier this week. But there's a good chance the correction in oil will undo a lot of that negative sentiment. Oil fell 3.1% yesterday.

Incidentally, we think there is a way to make money out of nickel. It has nothing to do with Minara. What it does involve is a company that has devalued almost 40% this year. If you'd like to see a few solid reasons why it can undo that, take out a subscription to Diggers & Driller.

Inflation refused to go quietly into the night yesterday. Instead it stormed up to its room, plugged in its electric guitar, turned the volume up a little higher...and made a bit of a nuisance of itself.

The key consumer price figures for the June quarter came out yesterday. They amounted to further evidence that the RBA has little control over inflation any more. Economists expected consumer prices to rise 1.3% in the June quarter. They rose 1.5%.

Here's the breakdown, straight from the statistics bureau. The biggest movers are in red (inflation) and green (deflation).

Food prices fell largely thanks to a correction in grains prices. That's temporary. Transportation needs little explanation. The greatest oil spike of all time is responsible for the inflation there.

And here's our point: the cost of financial services rose by more than any other category. High interest rates may have something to do with that. The major banks raised their mortgage rates again this month. They're nearing 10% now.

So now, the RBA can leave interest rates up there and contribute to the inflating cost of the financial system. Or it can drop them and risk letting the economy overheat. It only has one lever to pull. Now it can pull the lever up and add to inflation. Or it can pull the lever down and add to inflation.

There's a chance this could throw the market comeback off-kilter. But investors certainly look ready to run with the good news.

Alan Robinson
The Daily Reckoning Australia

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