NEW YORK: Traders are bracing for more volatility in markets as fighting in Iraq intensifies, with the recent rise in crude oil prices posing risks to the strong rally in US stocks.
Bank of America Merrill Lynch analysts said in a note that US$125 per barrel for Brent - near the highs hit in 2011 and 2012 - is on their watch list. Others have said the Brent peak near $150 in mid-2008 could be in play.
In that case, expect more weakness in transports and airlines. During last week's 4% rise in oil prices, the S&P 500 fell 0.68%. But the Dow Jones Transportation Average slid 2% and the NYSE ARCA airline index lost 4.9%. The 10-day correlation between the XAL and Brent is at -0.86, the strongest inverse relation since September.
The price of US wholesale gasoline also jumped last week, up 4%, and brushed against its highest since July. Analysts fear that a steady climb could hit consumer spending.
"We already have the evidence in that the recovery is slow," said David Kotok, chief investment officer at Cumberland Advisors in Sarasota, Florida. He said for every $1 a gallon of gasoline rises, about $150 billion in spending power is taken out of the hands of low- and middle-income American households.
"The most likely thing to happen is this schism is not going to be resolved in a peaceful way," he said. "We have a growing war with growing intensity."
The market has already taken note. Consumer discretionary stocks on the S&P 500 fell 1.7% last week and the retail index fell 2.3%, the most for both since April. Wal-Mart lost 2.5%, while Dollar Tree fell 2.2% in its first weekly drop in four.
Investors will likely continue to pile into energy shares. The S&P 500 energy sector, which was down on Tuesday, is up 9.6% so far this year. The sharp move has pushed the energy sector into overbought territory, measured using an index of relative strength, leaving it vulnerable if the Iraq situation is resolved.
Oil volatility spiked last week, with the CBOE Crude Oil ETF Volatility Index up more than 30% to its highest level since late April.
Meanwhile, the CBOE Volatility Index, the market's favoured indicator of anxiety, may for a time become a proxy for investors' concerns about the Middle East. Investors are slowly starting to pay a bit more for insurance against violent market moves - though at this point such hedges are still cheap.
The VIX recently traded at its lowest since 2007, but it rose 13.5% last week. At 12.2 it is still far below its historical average of 20 and the average in the last year of 14.3.
"My guess is over the next few weeks and months the VIX will tightly follow oil prices. If oil continues to rise, I think you're going to see a more pronounced spike in the VIX," said Russ Koesterlich, global chief investment strategist at BlackRock in San Francisco. - Reuters
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