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Oil Prices Gush, Stock Market Slides

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Oil Prices Gush, Stock Market Slides

June 22, 2008

After months of struggling to assess the impact of a crumbling real-estate market, many stock investors are focusing more on another worry: Just how badly will high oil prices eat into economic activity and share prices?

In years past, whenever oil prices pushed higher, a debate would ensue over whether the latest increase would cut into economic growth. And for years, pessimists were wrong. Higher fuel costs were absorbed by consumers and businesses without much of a blip.

But in 2008, it increasingly appears that the energy price rise will slice a meaningful amount off the already weak pace of economic growth and further batter corporate profits — bad news for stock prices.

The stock market has certainly taken a hit from the latest surge in oil prices. Starting in mid-March, the market began a strong rebound thanks to the Federal Reserve’s efforts to stabilize the financial markets following the collapse of Bear Stearns. By early May, the Dow Jones Industrial Average had rallied 11% from its 2008 low.

Giving Back Gains

But since then, oil prices hit a record close of $138.54 a barrel on June 6 and the Dow industrials have fallen back by 9.3%.

Last week, the Dow fell 3.8% — back below 12000 — bringing its year-to-date decline to 10.7%. It’s down 16.4% from its all-time high last October.

Why is oil having such a big impact this time around? A big reason is the speed of the rise. At $134.62 a barrel Friday, oil is up 40% this year and up a staggering 97% — or nearly double — from a year ago. In contrast, over the preceding two and half years, through mid-June 2007, oil prices rose 57%.

A slow, steady rise can be gradually absorbed by businesses or passed on to customers. But in this case, businesses will be hard pressed to pass on more than a fraction of the increase in energy costs.

Associated Press

Making matters worse, prices have also leapt on a wide variety of commodities, ranging from steel and copper to corn and wheat. Coming at a time when many companies are already experiencing slowing sales thanks to the weakening economy, the end result is shrinking profit margins and ultimately thinner profits.

Meanwhile, as any car owner knows, with gasoline over $4 a gallon, household budgets that are already feeling the pinch of falling home prices and a weakening job market are under increasing strain.

“It’s real money,” says Mark Zandi, of Moody’s, of the squeeze caused by higher gasoline prices. Back in 2002, Americans spent an average of about 4% of their budgets on energy; now it’s up to 6.5%. For households in the bottom quarter of incomes, 11.6% now goes to energy costs. “People have to make hard choices — do I fill up my gas tank or go out to dinner or do I make my mortgage payment,” Mr. Zandi says.

Economists say that the overall toll on the economy will be to subtract one third to one half of a percentage point from growth in gross domestic product. GDP is expected to rise an anemic 1.2% for 2008.

“One third of a percentage point doesn’t sound huge, but it’s noticeable,” says Jan Hatzius, chief U.S. economist at Goldman Sachs.

Safe Havens?

Just about the only stocks that have done well this year are those that profit from the global boom in energy and other commodities. Jumping on board those kind of winners is a bet — which might pay off — that prices will stay high or go higher. But given the steep rise in energy and commodities shares, many professionals fret they could fall equally dramatically.

Meanwhile, because the ripples from higher petroleum prices — along with those for other commodities — spread so widely throughout the economy, it’s a challenge for investors to find parts of the market that won’t feel the bite.

Many Wall Street strategists favor technology stocks, in part because higher energy prices don’t have a direct impact on production or on decisions by clients to buy new tech gear. The risk, however, is that the overall sluggishness of the economy dampens technology profits.

Tech stocks have fallen about 7% so far this year.

Similarly, health-care stocks aren’t directly affected by energy prices. But there are election-year worries about the potential for policy changes that could hurt the bottom line of many health-care companies; that could keep those stock prices depressed as well.

Thomas Lee, a strategist at JP Morgan Securities reckons that with oil north of $125 a barrel, households will be paying an extra $94 billion in energy costs this year. That’s equal to a 1% drop in disposable income for American consumers.

Eating Into Income

For businesses, Mr. Lee figures that higher energy bill will amount to $51 billion after taxes are factored in. Some energy companies benefit from higher energy prices, of course. But overall, he figures it’s enough to shave 5% off the earnings of the companies in the Standard & Poor’s 500-stock index in 2008, starting with second-quarter earnings reports coming out next month. (He assumes companies are able to pass on about 40% of the rise.)

Hardest hit by the fuel-price rise are auto makers, which are seeing reduced demand for large gas-guzzling vehicles, and airlines. Since the start of the year, auto stocks are down 21% and airlines, where bankruptcy is a real threat, are down 33%. Also feeling the pinch are casinos, where stocks are down 32%, since the cost of gas is keeping consumers home.

However, some discount retailers are thriving thanks to shoppers in search of a bargain. For example, Wal-Mart Stores reported stronger than expected earnings, thanks in part to consumers deciding to spend fiscal stimulus checks at the chain.

High energy prices have lowered expectations for the rest of the year. A number of Wall Street strategists think stocks could head roughly 10% higher by year end. But that would only take the market back to territory where it started the year.


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