Oil Rally May Stall Rebound By US Economy, Stocks

The continued surge in oil prices is starting to cut into economic growth--and with it, the slowly recovering stock market.

So far, the economy and stocks have taken the unprecedented rise in energy costs in stride. But that's beginning to change.

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Higher oil costs already are curbing some discretionary spending by consumers, which could slow the economic recovery. The stock market, in turn, could see its recent rally stall on worries about oil's impact on inflation and economic growth. That's largely what happened in the market on Wednesday.

And if stocks fall back, investors are likely to put more money in oil and other commodities, pushing prices up even more.

In total, analysts paint a complicated and somewhat dour picture of the far-ranging effects of the oil bubble.

"The relatively bad economy is going to continue through the summer, which is going to put a damper on things," says Michael D. Cohn, of Atlantis Asset Management. "That's partially a result of the ridiculously high oil prices, so I think it's going to affect the market this summer."

Cohn and others are somewhat baffled in particular at the disconnect between the dollar and oil. Traditionally a stronger dollar means weaker oil and vice versa. But as the dollar has picked up 2 percent against the euro since last week's Federal Reserve Rate cut, oil prices have jumped about 10 percent.

It's a trend that could be troublesome for the economy, though there is belief that the pattern could go back to normal should the Fed indicate a long-term intention to defend the dollar.

"The price of oil is a tax on the economy," says Brian Battle, an analyst at Performance Trust Capital. "There's a dollar problem, and maybe one of the things we can do to address oil is start getting footing back under the dollar and start putting the dollar back in the forefront and start making the dollar more valuable by stop lowering interest rates."

The Market Doesn't Seem to Mind

Yet even as oil has continued to climb--up 27 percent in 2008 and 98 percent in the past 12 months--the stock market has held its ground.

The strength in stocks comes from a number of sources and has occurred, some analyst say, in spite of oil rather than because of it. Many believe the worst for Wall Street came during the Bear Stearns bailout. Yet others see the housing collapse at or near its end. And still more see the massive banking writedowns from the subprime mortgage fallout as yet another reason to believe the market has nowhere to go but up.

But that belief could be shattered should oil not take a fall many predict and instead hold at it stratospheric levels.

"If we do see oil stay in the range north of $100 through the summer you'll definitely see spending habits change, but I think at this point people are still of the belief that this is somewhat of a terrorist issue associated with Nigeria and is somewhat temporary," says John Massey, senior vice president and portfolio manager at AIG Sun America Asset Management. "If the mindset changes to seeing this as more of a permanent long-term effect you'll start to see the impact be much greater."

Some, though, continue to wonder how the stock market can continue to sustain growth for a commodity that literally fuels the heart of the US economy.

Perhaps, some say, the market already has taken its lumps for oil, much as it has done for the subprime fallout, and is ready to move on with $3.50 a gallon gas as just another way of life while maintaining optimism that prices will ease in the future.

"There's an interesting dichotomy of what's going on. I think to some extent we as consumers have digested these prices and we're still doing our thing," says Nadav Baum, managing director of investments for BPU Investment Management. "Everybody's so focused on today. The market's obviously saying six, nine, 12 months from now this picture is going to be a lot different."

The Market Play

The natural move off high oil prices would seem to be into oil, but money managers caution on concentrating portfolios too much towards energy.

"In the short term, I think it's going to be extremely volatile," says Sean Brodrick, a natural resources analyst with Weiss Research who has forecast $157-per-barrel oil over the next six to 12 months.

As such, most are advising cautious plays with a bias towards industry-tracking ETFs and mutual funds that minimize risk while maximizing exposure to a broad array of investments that are influenced by the price of oil.

"At these prices I think you've got to have exposure to oil in your portfolio," says Matthew Tuttle, president of Tuttle Wealth Management. "If you're just now coming into it and saying, 'Now I'm going to jump,' I'd be very careful. While I do think the longer-term trend is up, I know in any bull market you can have some serious corrections."

Tuttle advocates the ProFunds exchange-traded funds, which offer double returns on short moves. The ProFunds Ultra Short Oil & Gas Fund and the Short Oil & Gas Fund are examples.

Baum also has advised his customers to scale back some on their energy exposure because of possible volatility but likes the Energy Select Sector ETF that tracks the movements of major energy producers like Chevron and ExxonMobil.

There is a fairly broad consensus among analysts regarding sectors outside energy. Most favor health care and technology while advising against consumer discretionary.

Massey of AIG likes medical technology company Hologic, which he sees growing 20 percent in the coming year, as well as Dow staple Procter & Gamble which trades at an enticing 18 times earnings as a health care play.

Atlantis's Cohn also points out that the commodity trade is far from dead, a sentiment echoed by Tuttle and others.

"The commodity play is still alive and well. The fact is, $4 a gallon gas plays into a lot of other commodities out there," Cohn says. "The demise of the commodity play was way premature here. What's been good in the past is going to be good in the future."