Oil still has a chokehold on stocks

Oil crash: Winners vs. losers
Oil crash: Winners vs. losers

Oil and stock prices are in an intense tango lately, with oil dictating the moves.

When crude oil prices swing up, stocks follow closely in quick step. And when oil slides lower, it sweeps the stock market down with it.

"You hate to see the market trading in conjunction with oil. There really is nothing more volatile on the planet," says Michael Baele, senior portfolio manager with the Private Client Reserve at U.S. Bank.

So far in 2016, oil and the S&P 500 have moved together 87% of the time. It's been in an even tighter embrace in the past two weeks, when the correlation jumped to 96%.

It's playing out again Tuesday. Oil prices plunged 5% after Iran called Saudi Arabia's plan to freeze oil production a "joke." Shortly after that, stock losses accelerated.

This is not normal. There's been almost no relationship between stock and oil prices in the past decade.

Until the dance between stocks and oil ends (or at least slows down), expect more wild market swings.

Related: Warren Buffett is betting big on oil stocks

At first, this close relationship doesn't make much sense. Oil prices have been plunging since the fall of 2014. Why is there such a close relationship with stocks now?

Plus, the common wisdom is that cheap oil should boost the U.S. economy since people and businesses are saving money on gas that they might spend on other items.

But there are three key reasons oil has become so interlinked with U.S. stocks in 2016.

Related: Iran calls Saudi oil production freeze a 'joke'

1. It's the economy, stupid.

Falling oil and stocks are indicators of how much fear there is of an even bigger global economic slowdown, especially in China.

"When stock traders respond to a change in oil prices, they do so not necessarily because the oil movement is consequential in itself, but because fluctuations in oil prices serve as indicators of underlying global demand and growth," wrote former Federal Reserve Chair Ben Bernanke in a recent blog post.

Related: Why people are freaking out about cheap oil

2. The spillover effect of cheap oil

As oil prices stay "lower for longer," more and more energy companies are going bankrupt. And it's only likely to get worse. Other oil-related businesses aren't quite at the bankruptcy stage yet, but they are defaulting on their bond payments because they don't have enough cash to pay.

But there's starting to be a spillover effect. Even companies outside of the energy sector are beginning to find it harder to issue debt, especially high-yield debt.

"The cost of borrowing for the entire basket is going up," says Jason Pride, director of investment strategy at Glenmede. Every time oil prices fall again, stock traders seem to fear the spillover effect could get wider.

Related: British oil industry warns it may collapse

3. OPEC and the U.S. won't scale back production

The world has too much oil right now. Someone needs to cut back. For months, experts predicted U.S. energy companies would scale back production. Then they thought OPEC might do it.

So far, no one is budging. OPEC -- especially long-time foes Saudi Arabia and Iran -- can barely agree on a freeze in production, let alone an actual cutback.

In 2016, investors finally seem to be coming to terms with the reality that oil prices are going to stay low for a lot longer than anyone thought.

This increases fears that the energy sector crisis will spill over and that emerging market countries that are heavily dependent on exporting oil will keep selling stocks to raise cash.

Until there's a clear sign that oil has bottomed, the market is likely to remain closely tied to oil.

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