Effect on investors of the fear of rising oil prices exaggerated

Although we have experienced a slight pullback in oil prices, many people are concerned as we head into the winter months. Consulting Group Senior Financial Writer Jack Guinan addressed these fears in a recent article. I have extracted some of his thoughts and comments.

Like a creature from a Hollywood horror movie, rising oil prices has reared its ugly head once again, striking fear in the hearts of investors. The gooey substance threatens to mire the economy and wreak havoc on the stock market. But is the only thing investors have to fear ... fear itself?

It's the unknown that most frightens people as faulty perceptions lead to distorted views. As oil prices hit all-time record highs, investors should step back, look at the realities of rising oil prices and not be moved to panic by the sensational news headlines. After calm consideration, investors may find that what is floating on the surface could be distorting the truths hidden beneath.

The price of oil is one of the most important macroeconomic factors in the economy. The consensus among economists is that a relationship does exist between oil prices and stock prices. However, getting a handle on the extent can be, in a word, slippery.

For example, the top 10 largest average monthly oil price increases from 1970 to July 2005 reveal scant evidence of a strong relationship. In January 1974, the first year of the Arab oil embargo, oil prices leapt 134.57 percent to $10.11 per barrel. Yet the S&P 500 Index declined only 1 percent.

In August 1990, oil jumped 45.8 percent, but stocks dipped a modest 9.43 percent. In August 1986, both oil and stock prices moved in lockstep, rising 30.38 percent and 7.12 percent respectively. In fact, the S&P 500 Index rose simultaneously with oil prices 60 percent of the time during this period.

Investors, who were frightened out of the market during these oil prices spikes, missed the positive gains made by stocks during this time.

Investors need look no further than the local gas pump to see the effects of surging oil prices. Higher gasoline prices have left many with less money to spend on other goods and services. As consumer-spending represents two-thirds of our gross domestic product (GDP), any pullback can have a negative impact on economic growth. That, in turn, can negatively impact corporate sales, earnings and ultimately stock prices.

Keep in mind, however, that gas prices are reported in nominal dollars, not in constant or real dollars - that is adjusted for inflation. This makes current price trends appear more menacing than they actually are.

According to the Energy Information Association, Americans paid in nominal dollars an average of 65 cents per gallon for motor gasoline in 1978. In 2004, this price increased 195 percent to $1.92. However, after adjusting for inflation, the rise was much lower (24 percent), and at the inflation-adjusted price of $1.78 was actually 51 cents lower than the 1981 peak real price of $2.29. In real-dollar terms, today's gasoline prices are lower than those peak prices of previous years.

Crude oil prices in real dollars also paint a different picture. The price of oil, adjusted for inflation, is still well below 1980 peak prices. And in real terms, the nominal price of $60.57 hit in July 2005 is actually just $11.75. Oil prices would have to rise to roughly $90 a barrel to match their previous high in inflation-adjusted dollars.

The recent surge in oil prices has bred fear, frustration and anxiety for consumers and businesses alike. It's a concern that investors should not overlook, but it's important to consider the event in its totality. While rising oil prices can contribute to a slowdown in GDP growth, a decline in stock prices is not inevitable.

Oil prices are just one factor of many that impact the economy and the stock market. Others include interest rates, weekending sales and production, global economic conditions, changes in consumer sentiment and even catastrophic events.

People and businesses make decisions based on expectations about oil prices. If decisions are made based on the expectations of high or low energy prices, and the energy market varies sharply from those expectations, firms and consumers may make inappropriate business decisions.

The data in this article, like all historical data, is just that, in the past. Future oil prices and stock movements may not follow the same historical pattern. But history demonstrates that oil prices and stock prices are fluid, and at times volatile. It's important for investors to understand the risks inherent with all aspects of investing.

• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm at 6005 Plumas St., Ste. 200 Reno, NV 89509.