The price of crude fell from more than $76 a barrel in early October to below $60 currently — a decline of more than 20% — and both oil bulls and bears should be on guard about the meaning of this steep slide.
On the one hand, there’s President Donald Trump celebrating oil’s plunge, just as he complained in late September about oil’s price being too high. On the other, many analysts are expressing concern that the lower price of oil reflects the slower economic demand of an imminent downturn. This concern gained special credence following Monday’s 600-point plunge in the Dow Jones Industrial Average (.DJI).
Neither of these simplistic views is supported by the historical data. A close analysis of past data shows that sometimes a higher oil price has been good for the stock market, and sometimes not.
In particular, there appears to have been a major shift in the oil-stock correlation about 15 years ago. Up until then, a rising oil price in a given month was more often than not followed by the S&P 500 (.SPX) falling over the subsequent month — and vice versa. Since then, in contrast, the relationship has been just the opposite: Now higher oil prices in a given month typically are correlated with higher stock prices in the subsequent month — not lower. (See accompanying chart.)
Both the inverse correlation for the earlier period, and the positive correlation subsequently, are significant at the 95% confidence level that statisticians often use when determining that a pattern is genuine. That these two otherwise significant patterns are mirror opposites of each other suggests that these statistics alone are of limited value in explaining what’s going on.
There is much irony in this. The inverse correlation between oil and equities prior to the early aughts was robust enough to become the subject of a study in in a major academic journal: “Striking Oil: Another Puzzle,” which appeared in the August 2008 issue of the Journal of Financial Economics. The study’s authors were Gerben Driesprong of Erasmus University in the Netherlands, Ben Jacobsen of the TIAS Business School in the Netherlands, and Benjamin Maat, a portfolio manager at Gresham Investment Management.
Not only did this inverse correlation come to an end at virtually the same time that this study was published, it reversed itself into its opposite.
In an email, Professor Jacobsen speculated that this reversal was caused by the trauma from the 2008-09 Financial Crisis. Perhaps investors’ post-traumatic stress has led them to “react negative[ly] to anything out of the ordinary regardless whether it is positive or negative news,” he wrote.
Jacobsen added that he doubts that the inverse correlation’s disappearance will last forever, since it had shown up in the historical record for far longer than the positive correlation of the last 15 years. Still, he allows that it could take a long time before that previous pattern reasserts itself.
In the meantime, both bulls and bears need to look elsewhere than oil’s price for compelling stories about what the stock market has in store.
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