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Understanding the Special Relationship between Oil and the Stock Market

Understanding the Special Relationship between Oil and the Stock Market

The relationship between oil prices and the stock market has been a topic of discussion among academics, economists and traders alike for decades now.

The complexity of the links between oil and stock prices has been extensively explored by various authorities. These include the Bank of International Settlements (BIS), US Federal Reserve (Fed), US Energy Information Administration (EIA) and the International Monetary Fund (IMF). The outcomes of research by these authorities range between a strong oil-stock correlation to none at all.

This has created a divide between those with conventional views and those with contrarian views. Conventional financial theorists point out that there is a definite correlation between oil and stock prices. On the other hand, contrarians state that oil and equity prices complement each other in a cyclic manner, if at all.

As with most things in the financial sphere, the truth is expected to lie somewhere in the middle of these two opposing views.

The Conventional View

The relationship between oil and stocks is defined as an inverse correlation, according to conventional financial wisdom. This means that when oil prices rise, stock prices tend to fall, and vice versa.

The assumption here is that when oil prices rise, energy prices, as a whole, also tend to rise. This leads to systemic inflation, which then raises the sunk costs that are absorbed by companies through their daily business activities.

As a result, profitability takes a major hit. To cope with these situations, investors usually sell off their stock holdings, which then affects prices in the stock market.

What Research Suggests

Now, the question that arises is whether this view correctly explains the relationship between oil and stock prices. Here’s what research reveals.

A study conducted by Forbes examined the possible correlations between crude oil prices and the Dow Jones Industrial Average (DJIA). Prices between December 16, 1990, and January 25, 2011, were analysed. A number of patterns emerged in the pricing behaviour, such as:

  • Between January 7, 1997, and February 16, 1999, oil and stock prices appeared to share a negative correlation of -0.84
  • Between February 19, 2009, and April 27, 2011, oil and stock priced witnessed a positive correlation of +0.94
  • There were several periods of minimal correlation between -0.30 and +0.30
  • On the whole, there was an aggregate positive correlation of +0.69

A similar study was conducted by Brookings Institution, under the leadership of former Fed chairman, Ben Bernanke. Here, the prices of WTI crude and S&P 500 stocks were analysed for between June 2011 and December 2015. The results showed a short lived, positive correlation between the two.

A 2008 study by Andrea Pescatori, economist at the IMF, also revealed the same results. Pescatori found that the variables moved in the same direction simultaneously, although it happened rarely. The study, with a confidence level of 95%, stated that no correlation existed between the two.

These studies concluded that the conventional view holds true only some of the times.

Reason for the Almost Zero Correlation

There are several explanations as to why economists have been unable to find any significant correlation between oil and stock prices. The most obvious reason is that there are several other price factors, such as industrial metals, wages, plastic and computer technology, interest rates and wages, that could balance out the changes in energy prices.

A second possibility is that companies have become wise in reading the futures market. So, they are able to predict any potential shifts in prices in a better way. This enables them to switch production processes in order to compensate for any increase in fuel costs.

Some economists are of the view that the general stock prices usually rally on expectation of an increase in the money supply. This happens independently of the change in oil prices.

The Real Driving Factors

So, a line needs to be drawn between the primary drivers of stock and oil prices. Oil prices are controlled by supply and demand of petroleum-based products. In the event of economic expansion, prices could increase due to a rise in consumption, while prices could dip due to increased production.

Stock prices rise and fall according to investor risk tolerance, future corporate earnings reports and intrinsic values, among other factors. Even if stock prices are lumped together, there is a possibility that oil prices could affect some of the sectors to a greater extent than others.

This shows that the economy is far too complex to expect a single commodity to drive all business activity in a predictable manner.

The Transportation Sector and Stock Prices

The only sector that bears a strong correlation with spot prices of oil is transportation. This seems logical, since the primary input cost for transportation companies is fuel. So, investors may prefer shorting stocks of transportation companies when oil prices rise. Conversely, it might be better to buy stocks of such companies when oil prices are low.

Although most studies point to rare correlations between oil and stocks, there is a bit of uncertainty over their validity. Researchers at the Federal Reserve Bank of Cleveland studied price movements and found that there is little correlation. So, while this does not prove that the impact of oil is limited, it does suggest that analysts cannot completely predict the nature of the relationship.

By now, it must be clear that proving or disproving a correlation can be a very tricky thing. There are always a number of factors that could affect the results.

If you want to trade on the basis of the oil and stock price link, you need to be aware that the relationship can be unpredictable. So, make sure you use the best technical analysis tools, while staying abreast of economic releases, to make informed trading decisions.

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