Wednesday, March 09, 2011

Oil and Stock Prices Correlation

The guys at Bespoke Investment Group research have done it again, a quite important piece of discovery - the correlation between stock prices and oil prices. Oil prices, much like the price of gold has not really dented the stock markets upswing for the past 12 months. Each time gold prices or oil prices inches higher, the stock markets greeted it with a weak applause. Theoretically both oil prices and gold prices should have a significant "negative" impact on stock prices. Why have these two not affected share prices?

Oil prices because of the lowering of margins for many industries, and for impacting negatively on the cost of final goods and services. Gold as a reflection of inflationary fears or market disequilibrium or global unrest fears.

Bespoke: From the start of the bull market back in March 2009 until just recently, oil and the stock market had a seemingly wonderful relationship. Most of the time, when stocks moved higher, oil moved higher as well. On the rare occasion that equities headed lower, oil tagged along to the downside. This wonderful relationship has recently become strained, however, and the two have seemingly chosen to go their separate ways.

Below is a chart highlighting the rolling 1-month correlation between the S&P 500 and oil (using daily % changes) since the start of the equity bull market on March 9th, 2009. The higher the number on the positive side, the more closely the two are moving together. The lower the number on the negative, the more the two are moving in the opposite direction. As shown, the correlation between the stock market and oil remained positive up until just recently, but the breakup between the two has been swift and extreme. At the moment, the one-month correlation between the two stands at -0.70.

The correlation chart is a good way of showing how high the stock market was allowing oil to go before oil's price began to affect stocks. Oil rallied alongside stocks from the $30s to the $80s, but once it got into the high $80s and then broke $90 and finally $100, the stock market began to break away and move lower. With oil now into the triple digits, stocks are simply heading in the opposite direction of the commodity on a daily basis.

The question everyone has now is whether the stock market can adjust to oil at these levels, or whether oil will need to pull back before stocks can start to head higher again.

The thesis that share prices can only stomach the price of oil up to a certain extent sounds good but difficult to stomach logically. Bespoke said that only when oil prices move past $80 that they start to affect share prices. To me, its an argument but not entirely persuasive. One may say that up to $80, industries can safely pass on the higher cost of oil without impacting on final demand. Things turn awry beyond $80 as end consumers would not be able to accommodate further jumps in product prices.

While the above para sounds plausible, I have another theory for the correlation chart anomaly. Share prices have been rising despite oil moving higher from $60-$80 because the world and most companies have already come to terms in living and managing in a world with high oil prices. Ask most companies, they would have spreadsheets pricing oil at $90, $100, even $130 or $140. We drivers have learned to live with ever increasing fuel and gas prices, 2 or 3 times a year anyway.

Another plausible way to explain the correlation anomaly is the something out of the ordinary has occured whereby stock prices would then go into tailspin regardless of how oil price moved. Are the Libyan and Egypt crises such type of events? I think by itself, these two events are not sufficient to rock the boat. The alarming thing was how pervasive and viral it became, suddenly almost all of the Middle East and parts of North Africa may be in for a sustained revolt, that may explain the divergence in correlation. We now have a better understanding that the other nations may not implode the way Egypt did or Libya is experiencing, maybe I should not use the word "implode", maybe I should use "regenerate" or "rejuvenate".

I believe the $80 turning point is only one of the major turning point to end users to explain the divergent behaviour of share prices beyond that level. The other would be the speculation. Call it whatever, black swan anticipation theory, hedging, etc... once oil prices surges past $80, we saw a lot of scrambling by corporations, traders, hedge funds, the run of the mill fund managers, private bankers etc... to take speculative positions of do hedging for their portfolios, revenue streams, protection on their costing model and raw materials.

The surge in activity probably sent oil prices to an overzealous territory. Oil prices is a very liquid instrument for all. All it took was for the top few hedge funds who were happy going long in stocks, to start to cash out of stocks and then "play oil futures" as their new temporary playground, causing a rush for the party, causing some over heightened anxiety by genuine businesses - which is why i still think the price of oil is overplayed now. How else can you explain fully the divergence from the chart above. Purely on the fact that oil price beyond $80 is really bad does not cut it for me.


cina.fong said...

Wei Mr Dali, you are getting a tad technical here for the past few posts. Mostly we readers just want to know is the market going to continue its green momentum and is it safe to go back in? Ok, I was only kidding on the last bit.

Good write up thought *wink*

ys said...

Another possibility for a negative correlationship is due to the "price stickiness downwards" effect. When oil prices go up, manufacturers' will eventually pass on the costs to the consumers but when oil prices revert to mean (assuming the initial jump in price is due to temporary supply shock), prices of goods and services tend to stay where they are, thus a surplus of profits which is being priced in now.

Media Mentions said...

Oil prices really seem to be the in all and be all of everyday conversation now, but your post really helps put things in order, especially when there is so much conflicting information out there. (Although there is one article I read today that's likewise very insightful:

anyway, thank you for the post!