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Investment Strategy

Will Retailers Rally Because of Lower Oil Prices?

By Elliott H. Gue, on Nov. 12, 2014

West Texas Intermediate (WTI) and Brent crude prices have tumbled almost 30 percent since late June and building supply in North America should prevent oil from rallying over the next few months.

Against this backdrop, the average cost of a gallon of unleaded gasoline has tumbled from a year-to-date high of about $3.70 to an almost four-year low of $2.92.

When gasoline prices drop, pundits often call for investors to buy retail stocks, arguing that falling prices at the pump are akin to a tax cut, freeing up cash that consumers can use to purchase all manner of discretionary items.

The average US household spends about $3,000 on gasoline annually; a sustained 20 percent drop in fuel prices returns about $600 to consumers’ budgets.

This stimulatory effect is magnified in households earning less than $50,000 per year in 2001 dollars.

According to Energy Cost Impacts on American Families, 2001-2014, these consumers spend about 19.6 percent of their after-tax income on energy—8.1 percent on electricity and heating and 11.5 percent on transportation fuels.

Household Income -- Stimulation

Households that earn at least $50,000 in pretax income spend an average of more than $5,200 per annum on energy, or about 8.2 percent of their total take-home pay.

The marginal propensity to consume is higher among lower-income households. That is, a household with less than $50,000 in after-tax income is more likely to spend $1 in saved gas money than a household with more than $50,000 in after-tax income; higher-income consumers tend to save more of their excess cash.

Accordingly, lower gasoline prices help to bolster consumer spending, especially at the lower end of the income spectrum.

The energy sector accounts for about 9 percent of the S&P 500’s market cap; these stocks, especially names involved in exploration and production, have taken quite a hit in anticipation of weaker earnings.

Yes, the shale oil and gas revolution has driven huge employment gains in North Dakota and other drilling hotbeds.

But some perspective is necessary: Although lower oil prices could constrain job creation in the energy sector, oil and gas extraction accounts for only 1.2 percent of US gross domestic product (GDP) and employs 215,600 of the almost 118 million people in the nation’s private workforce.

The manufacturing sector, on the other hand, employs more than 12 million Americans and contributes between 12 and 13 percent of US GDP. These factories consume energy to churn out their products; this segment of the economy stands to benefit from lower oil and natural-gas prices.

Falling oil prices are good for the US economy as a whole. However, the link between consumer-discretionary stocks and crude-prices isn’t as straightforward as you might assume.

Retailers and Energy Prices

During media giant Walt Disney Co’s (NYSE: DIS) conference call to discuss results for its fiscal fourth quarter ended Sept. 27, an analyst asked CFO James Rasulo about the effect of lower energy prices on the company’s bottom line.

Conventional wisdom holds that lower gasoline prices help to drive attendance at Walt Disney’s theme parks, a business that generates almost one-third of the firm’s total revenue. Rasulo explained why this assumption doesn’t hold water:

We’ve over the years been asked a lot of questions about oil prices and I can tell you that other than an indicator of overall economic activity, oil prices per se have never been a real driver for our business either on the upside or the downside. So I don’t expect there to be big movement, particularly in our Parks and Resorts business for that.

People tend to believe that, that would be very relevant. I don’t expect that to be a driver as it’s never been before on much more dire situations.

In terms of the strength of the dollar, obviously, I mentioned in my prepared remarks that we have an FX [foreign exchange] impact coming up. We’ve also had one this year. It was part of the reason, for instance, that International Parks was down due to the weakness in the yen. Obviously, we took the Venezuelan devaluation this past year below the line. And we expect to see a not gigantic but an impact from basically the conversion of our business, our foreign businesses into dollars.
Walt Disney historically hasn’t posted a significant uptick in earnings when oil has moved dramatically lower, especially when a stronger US dollar contributes to this downside.

However, Rasulo’s comment that movements in oil prices can serve as useful “indicator of overall economic activity” is particularly instructive. Check out our table tracking the correlation coefficients between oil prices and various US stocks and equity indexes.

Oil prices vs stocks

Positive correlation coefficients indicate that the security or index tends to move in the same direction as the price of WTI crude oil; negative readings indicate an inverse relationship.

Higher numbers on the positive side and lower numbers on the negative side indicate a stronger relationship. A 1-to-1 correlation would indicate that the two data sets move in lockstep.

The S&P 500 Energy Sector Index exhibits the strongest positive correlation to oil prices, which hardly comes as a surprise; rising energy prices boost the profitability of many energy-related companies (refiners are a notable exception).

But you might be surprised that all but two of the S&P 500’s 10 economic sectors—health care and consumer staples—tend to track movements in oil prices.

Given the positive effects of lower oil and gasoline prices on the US economy, you’d expect consumer-discretionary stocks to benefit from consumers’ higher levels of disposable income.

However, this sector tends to rally when the price of crude oil climbs, a reality that flies in the face of the conventional wisdom that retailers and other consumer-discretionary names benefit from lower oil prices.

This discrepancy occurs because oil prices often rise when the global economy grows at a healthy rate and demand increases. By the same token, oil prices tend to fall during periods of economic weakness; for example, WTI prices plummeted by almost 80 percent in less than six months during the Great Recession.

Because retailers and other consumer-discretionary names benefit from a strengthening global economy, these stocks tend to do well for the same fundamental reasons that crude-oil prices move higher.

The ideal scenario for retailers occurs when the global economy grows at a solid rate and oil prices fall—a rare confluence of events.

Between December 1996 and December 1998, the S&P 500 soared more than 65 percent while crude oil tumbled to $10 per barrel from about $30 per barrel. Over this period, the S&P 500 Consumer Discretionary Sector Index delivered a total return of more than 80 percent, tops among its peers.

Likewise, the S&P 500 Consumer Discretionary Sector Index jumped by 26.2 percent between July 2006 and January 2007, when oil prices fell to about $50 per barrel from $75. In contrast, the S&P 500 posted a total return of 15 percent over the same time frame.

Airlines and retail giant Wal-Mart Stores (NYSE:WMT) also tend to benefit from falling oil prices.

Over the past year alone, American Airlines (NSDQ: AAL) has spent more than $12.3 billion on fuel and generated total revenue of almost $40 billion; even a modest decline in the price of this critical input, flows directly to the carrier’s bottom line.

Wal-Mart Stores also tends to benefit from lower energy prices because these costs take a larger bite out of lower-income consumers’ disposable incomes.

The argument that retailers rally when oil prices fall oversimplifies reality; commodity prices are one of many factors that drive consumer-discretionary stocks.

For example, the personal savings rate, or the proportion of total disposable income that consumers set aside, provides meaningful insight into retailers’ prospects.

US Savings Rate

Between the mid-1970s and 2006, the US personal savings rate trended steadily lower, indicating that households were spending a greater proportion of their income. This changing attitude toward savings and spending provided a key tailwind for retailers and consumer-discretionary stocks.

However, the savings rate appears to have bottomed after the financial crisis. Today, consumers have refocused on saving money and reducing debt, creating a less favorable environment for retailers.

Credit conditions and debt service are also key considerations. Thanks to falling interest rates and a renewed propensity for saving, the consumer debt-service ratio (debt repayments as a percent of disposable income) has plummeted to a record low in recent quarters. Since consumers pay less to service their debts, they have more disposable income for discretionary purchases.

However, interest rates should head higher in coming years, increasing the cost of outstanding debt—a potential headwind for retailers.

What should you take away from this analysis?

  • Within the consumer-discretionary space, airlines, discount retailers and stores catering to lower-income consumers stand to benefit most from falling oil prices.
  • Investors shouldn’t buy retailers blindly via an exchange-traded fund to profit from lower oil prices. Hunting differentiated returns in this sector requires a rifle, not a shotgun.

In the next issue of Capitalist Times Premium, I’ll take a detailed look at the consumer-discretionary sector, identifying the stocks best-positioned to benefit from lower crude-oil and energy prices.

We booked a 20 percent profit on MetLife (NYSE: MET) and a 34 percent gain in Aetna (NYSE: AET) to clear some room in the Wealth Builders Portfolio for my latest pick.

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