Commodities Sell Off = Stock Market Sell Off?

Yesterday the Dow Jones Industrial Average fell the most it has in two months.  Ostensibly the sell off was because of the dramatic fall in commodities prices, including oil, gold and silver.  To me this is evidence of strange trading forces at work, rather than fundamental problems with the U.S. economy.

Let’s think about it.  If the cost of fuel falls isn’t that good for almost the entire U.S. economy?  After all, the only businesses who cheer high oil prices are the oil companies themselves.  Every other business and every consumer (even those at oil companies) celebrates lower expenses.  It’s impossible to be agnostic about this.  Businesses experiencing lower expenses have higher profits.  Consumers experiencing lower expenses have more money.  Duh!

So shouldn’t these higher profits actually lead to a stock market rally?  Why would lower oil prices lead to a sell off of the stock market as a whole?  Without the data it is impossible to precisely pinpoint the reason.  However, it is my feeling that the sell off is evidence of strange trading forces.

The first point is for me to quote a piece of research that an intern of mine did many years ago (hello Matt Schildt).  During the dot.com era where trading volumes for the S&P 500 were gigantic, on average only 0.6% of the ‘market’ traded on a given day.  In other words, very few traders determine the price of all U.S. equities in a given day.  So yesterday’s sell off is very likely to have been driven by a very small segment of investors who, nonetheless, were extremely vested in high oil prices.

My second point is: who would have such a vested interest?  That’s right, most likely it was a hedge fund that was unwinding a gigantic bet on high commodity prices, including oil.  That would also explain some of the bleed through from the commodities market into the stock market as hedge funds frequently have bets in multiple markets simultaneously.

In conclusion, that there was a big stock market sell off yesterday should not be seen as evidence of fear that the U.S. economy is not robust.  Instead, it should be seen as evidence of the peculiarities of the hedge fund world and its byzantine trading strategies.  If it wasn’t a hedge fund, it may just have been some big Wall Street investment bank with a similar, and gigantic bet, on oil prices and other commodities.

Jason