Stocks and oil prices

Oil prices and the stock market have moved in close alignment recently, drawing much attention from the financial press.

Many believe this is a rare coupling. More familiar headlines such as "US stocks rally after crude drops to 3-month low" (Wall Street Journal, Aug. 8, 2008) or "Oil slide spurs global equity rally" (Financial Times, Oct. 12, 2006) highlight the shared belief among journalists and stock market commentators that a decline in oil prices exerts a positive impact on the economy and stock returns-at least for net oil importers like the US and China-and vice versa.

In fact, notwithstanding such widely held views in the financial press, researchers for many years compiled mixed or even conflicting evidence regarding the nature of the relationship between crude oil prices and stock market returns.

Kling (1985) and Jones and Kaul (1996), for example, concluded that crude-oil price increases are associated with stock market declines. Chen, Roll, and Ross (1986) and Huang, Masulis, and Stoll (1996), in contrast, found no evidence of a negative relationship between prices of oil futures and stock returns.

In particular, in a blog article, Ben Bernanke, former Federal Reserve Chairman and currently distinguished fellow at the Brookings Institution, calculated the raw correlations of stocks and oil prices for the recent past 5 years using a 20-day rolling window. The results suggest that the correlation is itself volatile, swinging between positive and negative values. On average, however, the correlation is positive (stocks and oil move in the same direction).

"Although the correlation has ticked up in the past few months, it has not been unusually high recently, compared to the rest of the 5-year sample," Bernanke said.

Those conflicting viewpoints would suggest that the relationship between oil prices and the stock market is nonlinear or unstable over time.

So, what drives the variations? The nature of the relationship might crucially depend on the recent behavior of crude oil prices.

Work by Kilian and Park (2009) showed that the negative response of stock prices to oil-price shocks is found only when the oil price rises due to an oil-market specific demand shock such as an increase in precautionary demand driven by concerns about future crude oil supply shortfalls.

In contrast, shocks to crude-oil production have no significant effect on cumulative stock returns.

Finally, higher oil prices driven by an unanticipated global economic expansion have persistent positive effects on stock returns. This result arises because a global business growth will stimulate the US economy directly, while at the same time driving up the oil price, thereby indirectly slowing US economic activity. Since the stimulating effect dominates in the short run, the US stock market may indeed thrive despite unexpectedly high oil prices.

Kilian and Park's work actually supports one major explanation for the current co-movement, that is, both oil prices and the stock market are reacting to a common factor, namely, a softening of global aggregate demand.

However, as the energy sector has become more important to the US economy and the financial system, more explanations should be explored.

In the same blog article, Bernanke tested the demand hypothesis and found that an underlying demand factor does account for much of the positive relationship, and that if, in addition, accounting for shifts in market risk preferences, more can be explained.

However, even with these two factors included, a significant part of the oil-stocks correlation remains unexplained.

"There are several other explanations that could be investigated: for example, the possibility that declines in oil prices, even if initially caused by higher supply, affects global financial conditions by damaging the creditworthiness of oil-producing companies or countries." Bernanke said.