FXCM Insights

The Relationship Between Oil And Stock Prices

The existence of a correlation between oil pricing and stock market valuations have been a point of contention among economists, academics and traders for decades. Conventional financial wisdom alludes to the presence of a definite correlation between oil and stock price. Contrarians to this idea have stated that oil and equities complement one another on a cyclical basis, if at all.

The complexities of this link have been scrutinised for years. Authorities such as the International Monetary Fund (IMF), Bank Of International Settlements (BIS), U.S. Energy Information Administration (EIA) and the U.S. Federal Reserve (FED) have examined the topic extensively. Conclusions range from the presence of a strong correlation to no correlation whatsoever.

These results are not surprising because discrepancies in each study’s duration, inputs and methodology have built subtle biases into the outcomes. As with most things in the financial arena, the truth is likely to fall somewhere in the middle.

Conventional Wisdom

When it comes to the relationship between oil and stock pricing, conventional wisdom states that the two have an inverse correlation. In simplest terms, the relationship is as follows:

The underlying assumption adopted by this view is that when oil prices rise, energy prices rise as a whole. This causes systemic inflation, increasing the sunk costs absorbed by companies during the execution of everyday business operations.

In turn, profitability is hurt. As a result, traders and investors are prompted to sell off corporate stock and drive share price down.

Academic Study

So, does the conventional wisdom on the subject hold true? The answer is an indecisive yes and no.

In an observational study conducted by Forbes, possible correlations between the Dow Jones Industrial Average (DJIA) and crude oil pricing from 26 December 1990 to 25 January 2011 were looked at in depth. The following patterns in pricing behaviour were noticed:

The results of the investigation show a moderate correlation from 1991 to 2011, with periods of considerable positive and negative correlations. In effect, the exercise illustrated conventional wisdom holds true at least some of the time.

A similar examination of the subject was conducted by the Brookings Institution, led by former U.S. FED chairman Ben Bernanke. Although somewhat-volatile, a positive correlation between WTI Crude Oil pricing and the S&P 500 from June 2011 to December 2015 was observed.3)Retrieved 29 August 2017 https://www.brookings.edu/blog/ben-bernanke/2016/02/19/the-relationship-between-stocks-and-oil-prices/ Essentially, as the price per barrel of WTI crude oil rose, so did the S&P 500.

Interpretations And Conclusions

Seemingly several times every year the oil/stock price analogy is revisited by academia. In the midst of a large rally or the pronounced selloff of an equities indices, energy pricing is a favourite culprit. Promoting dependency between the two asset-classes is a pastime enjoyed by industry analysts and journalists.

At least for now, a consensus has not been reached. The results of formal studies are often contradictory and depend greatly on guiding parameters. Listed below are several factors that substantially influence the outcomes of any study based on market-related data.

Drawing definitive conclusions from studies based upon historical data analysis can be a challenge. It is important to recognise the role that pitfalls such as hindsight bias and data fitting can present to objectivity.

Summary

Proving or disproving a correlation can be a tricky business. There are many factors to account for, and often no obvious answer is present.

When it comes to the relationship between oil and stock pricing, at least a moderate correlation does exist. It is often cyclical and can be either positive or negative. The relationship is dependent upon any number of factors and can vary wildly.

If one is to engage the capital markets based on the oil/stock price link, it is crucial to keep the perspective as current and objective as possible.

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