Quick: What’s been the most important factor in stock market performance so far in 2014? While many investors would point to emerging markets, that only covers part of the story. In reality, natural gas has been an important fuel for the stock market’s moves — even on a minute-to-minute basis.
The High Correlation Between Stocks and Natural Gas
Why is natural gas so important? In addition to being an input cost for a variety of industries, it’s also a meaningful expense for consumers. Those of us whose houses are heated by natural gas became used to cheap energy in recent years: crank up the thermostat, because prices are so low the bill will still be affordable. Not anymore. This month, with natural gas up 30% for the year at its January peak, consumers will receive a shock once the heating bills start to roll in.
This scenario helps explain why the spike in natural gas prices has correlated almost perfectly with a decline in stock prices in general, and in consumer stocks in particular. Even the consumer staples sector — which is supposed to provide defensive characteristics in a downturn — has been hit hard in 2014, in part due to the fear that consumers will need to shift their nondiscretionary spending to pay their heating bills.
Consider the following numbers. In 2013, the prices of the SPDR S&P 500 ETF (SPY) and U.S. Natural Gas Fund (UNG) had a correlation of -0.13. But so far in 2014, the correlation has blown out to -0.86. Keep in mind that correlations run on a scale of -1.0 to 1.0, with -1.0 indicating two securities that move in opposite directions and 1.0 showing two securities that move in lockstep. As such, a correlation of -0.86 shows that SPY and UNG have moved from having little correlation last year to trading in almost perfectly opposite directions in 2014.
In terms of actual performance numbers, SPY’s average return on the eight days that UNG’s price has fallen in 2014 is -0.01% — roughly flat. In the 15 days that UNG rose, SPY has averaged a return of -0.33%. More notable than that 32-basis-point gap is the fact that the six worst days for stocks thus far in 2014 have all occurred on days in which UNG climbed.
Use This Negative Correlation to Your Advantage
How can investors use this information? In a general sense, putting UNG on your watch list can provide a sense of what’s driving the market during the course of any given day. For traders, however, tracking natural gas on an intraday basis can be particularly useful right now.
A prime example is the market action that took place on Wednesday morning. Note how, in the chart below, the drop in UNG provided about 15 minutes of lead time to the uptick in stock prices that occurred through the middle part of the day. The relationship won’t always be this clean, of course, but this chart illustrates how the performance of natural gas can help traders refine their entry points right now.
In terms of the broader market outlook, this negative correlation actually might be good news. While trying to predict the day-to-day moves in natural gas is a sucker’s game for individual investors, the fact that the commodity is already up so much this year — and has formed a double-top near $5.40 — may be a sign that the current move has reached exhaustion. If that indeed proves to be the case, look for stabilization in stock prices absent any further headlines from the emerging markets.
The tight relationship between stocks and natural gas won’t last forever, but it can provide a leg up to traders as long as it does. In the meantime, keep an eye on UNG for clues as to what might be next for the stock market.