07 Jun 2019
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 ViewThe 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 SuggestsNow, 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