This is Part III of the series "Robert Prechter Dispels 10 Popular Investment Myths," where EWI president explains why traditional financial models failed -- and why they are doomed to fail again (and again). (Excerpted from Prechter's February and March 2010 Elliott Wave Theorists.)
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Part I and Part II; come back on Monday, December 13, for Part IV.
The Socionomic Theory of Finance
The Conventional Error of Exogenous Cause and Rational Reaction
By Robert Prechter
Claim #2: “Rising oil prices are bearish for stocks.”
This is a ubiquitous claim. It would take weeks to collect all the statements that economists have made to the press to the effect that recently rising oil prices are “a concern” or that an unexpected (they’re always unexpected) “oil price shock” would force them to change their bullish outlook for the economy.
For many economists, the underlying assumption about causality in such statements stems from the experience of 1973-1974, when stock prices went down as oil prices went up. That particular juxtaposition appeared to fit a sensible story of causation regarding oil prices and stock prices, to wit: Rising oil prices increase the cost of energy and therefore reduce corporate profits and consumers’ spending power, thus putting drags on stock prices and the economy.
Figure 7 shows, however, that for the past 15 years there has been no consistent relationship between the trends of oil prices and stock prices.
Sometimes it is positive, and sometimes it is negative. In fact, during this period it has been positive for more time than it has been negative! And the quarters during this period when the economy contracted the most occurred during and after the oil price collapse of 2008. Thereafter oil prices doubled as the economy was reviving in 2009. None of this activity fits the accepted exogenous-cause argument.
But wait. Could rising oil prices perhaps be bullish for stocks? Yes, once again we can argue both sides of the exogenous-cause case. Consider: As the economy begins to expand, business picks up, so stock prices rise; and as business picks up, demand for energy rises as businesses gear up and operate at higher capacity. That’s why stocks and oil go up together. Makes sense, doesn’t it?
But neither claim explains the data. Sometimes oil and stocks go up or down together, and sometimes they trend in opposite directions. As with Figures 3-6 [see Part II -- Ed.], we could easily isolate examples of all four pairs of coincident trends. To conclude, we can determine no consistent relationship between the two price series, and no economist has proposed one that fits the data.
This graph negates all the comments from economists who say that an “oil shock” would hurt the stock market and the economy. It also throws into doubt the very idea that stock prices and oil prices are linked.