Wall Street bulls had hoped that a diplomatic breakthrough in the Middle East in June would fuel a rally in U.S. equities. So far, those hopes have been dashed.
Since mid-June, the S&P 500 has made little progress. That period coincides with signals from the U.S. and Iran that they were nearing an agreement aimed at ending their conflict in the region. Over the same timeframe, oil prices have fallen more than 20%, erasing much of the gains made since the war began.
This has dealt a blow to equity forecasters. Last month, they rushed to upgrade their views on the S&P 500, arguing that a U.S.-Iran memorandum of understanding would ease price pressures and support riskier assets. JPMorgan strategists suggested the peace deal could set the stage for a "clear skies" scenario for U.S. stocks.
For investors preparing for the coming weeks, which will bring the next round of corporate earnings, key inflation data, and a Federal Reserve interest rate decision, this trend could pose a near-term headwind.
In the view of closely watched investment veteran Jim Paulsen, the U.S. stock market's lackluster performance despite a double-digit decline in WTI crude oil prices aligns with historical patterns. Paulsen's analysis of data since 1970 shows that over the past 50 years, whenever oil prices have spiked, the S&P 500 has declined after oil prices begin to retreat.
In the past 10 similar instances, the S&P 500 fell an average of an additional 23% after oil prices peaked and turned lower. The most recent occurrence was in May 2022, when the index fell nearly 13% further after oil's peak, ultimately sliding into a bear market.
Paulsen stated in a phone call that the S&P 500 invariably goes through "a period of sideways movement or outright decline." As the damage from the oil price shock to the U.S. economy becomes increasingly apparent to investors, he forecasts the S&P 500 will drop more than 10% this year.
Although WTI crude is on track for a third consecutive monthly decline, Paulsen notes that the impact of oil prices being above $110 earlier this year is still working its way through the economy. U.S. Treasury and bond yields have not returned to pre-conflict levels. The same is true for the U.S. dollar, which poses challenges for American exporters.
"There have always been lagged relationships in economics, and oil prices are no exception," Paulsen said.
Clearly, almost no one on Wall Street expected the post-memorandum stock market rally to be linear. Paulsen also pointed out that stock market pressure following an oil price peak is historically a short- to medium-term phenomenon, adding that the duration of the declines varies.
Paulsen noted another challenge for the market: "Once oil peaks, most investors relax and become much more optimistic — a classic contrarian indicator." Indeed, a survey by the American Association of Individual Investors showed a "surge in optimism" by late June, with the spread of bullish over bearish responses reaching its widest since late April.
Nevertheless, the market faces near-term risks as investors and strategists continue to assess whether the lagged effects of the earlier surge in energy prices will spill over into the next round of inflation data.
In Paulsen's view, more economic pain from the oil price shock may be on the horizon.
"When oil prices rise, the immediate impact is fairly small." But he added that the full reaction is likely to manifest with a lag, and the market may not yet be prepared for it.
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