The Oil Price Impact – An Example of Risk Aversion Dominating Fundamentals

“Bottom line is, you pay attention to fundamentals and while the fundamentals are solid, and then you look at your screen and you want to throw up.” Philip Orlando, Chief Equity Strategist Federated Investors as quoted by Bloomberg 12 Dec 2014.

Does this sound familiar? Nearly every equity analyst and economic strategist must have this nausea as they watch the oil price fall, which is fundamentally good for most companies, yet global stock markets are selling off aggressively. As always, those who focus on fundamentals have overlooked the primary force determining asset prices – the risk premium.

Fundamentalists focus on the impact on future cash flows of a major event such as a massive decline in the oil price. Collectively, this should be good for aggregate profits in output producing countries such as the US, Japan, China, India, Europe and the majority of the world. This is because lower energy costs mean higher profits. While the energy producing countries suffer, the net effect should be positive for global equity markets – energy makes up only 10% of global output. On the fundamentals, stock markets should rise.

The problem is that fundamentals don’t matter that much in asset pricing. This is the insight from Robert Shiller, who demonstrated that market volatility is much higher than can be explained by cash flow volatility. Variation in the ‘market risk premium’, the rate of return that investors demand to induce them to bear risk, is the dominant parameter determining asset prices. The risk premium reflects investor risk aversion – and when investors get scared, the risk premium goes up which means that asset prices go down…