Tuesday, April 05, 2005

Do Higher Daily Oil Prices Mean Lower Stock Prices? (I)

Previously I took a look at the historical relationship between stock prices and inflation (http://lloydsinvestment.blogspot.com/2005/03/why-inflation-shouldnt-spook-market.html), and stock prices and interest rates (http://lloydsinvestment.blogspot.com/2005/03/do-higher-interest-rates-lead-to-lower.html). Based on the past couple of centuries of data, I concluded that the cause-and-effect relationship is quite weak in both cases: Neither high inflation nor rising interest rates have consistently led to lower stock prices.

With oil touching new highs (light sweet crude at $58 per barrel), typical financial reporting these days reads like the example below:

"Sellers show some resolve as $58/bbl oil pushes the indices back to session lows . . . Rising crude oil prices continue to dictate overall market action and underpin widespread nervousness . . ."

(Quote from Yahoo's Market Update: http://biz.yahoo.com/mu/update.html)

Just how true is it that higher oil prices "cause" stock prices to fall?

To provide an objective historical answer to this question, I downloaded oil prices and closing levels of the S&P 500 index for the past year. Here's what the data tell us:

(Oil prices are NYMEX Light Sweet Crude prices from the U.S. Energy Information Administration's database: http://www.eia.doe.gov/emeu/international/petroleu.html#IntlPrices)

Data Period: April 1, 2004 to April 1, 2005

Index: Starting Price, Ending Price, % Change
Oil: 34.27, 57.27, 67% rise
S&P 500: 1132, 1173, 3.6% rise

Average Daily % Change
Oil: 0.23%
S&P 500: 0.02%

Correlation: -0.15
Percent of Days with "Same Sign" Price Change: 127/250 = 51%
Percent of Days with "Opposite Sign" Price Change: 123/250 = 49%

Quintiles Sorted in Order of Decreasing Daily % Change in Oil Price
Quintile: Average Daily % Change in Oil vs. S&P 500
I: 3.3% vs. -0.2% (correl. = -0.26)
II: 1.3% vs. 0.1% (correl. = 0.01)
III: 0.3% vs. 0.2% (correl. = -0.15)
IV: -0.8% vs. 0.0% (correl. = -0.11)
V: -2.9% vs. 0.0% (correl. = -0.36)

The data indicate a mixed message:

1. The overall correlation is negative (-0.15), and the quintile data exhibit this negative correlation most strongly on trading days with more extreme changes in oil prices (-0.26 in quintile I and -0.36 quintile V);

2. However, during the past year, 51% of the trading days have shown crude oil prices and the S&P 500 moving in the same direction (i.e., either both up or both down), while 49% have shown price movement in opposite directions (i.e., one up and the other down).

So, the negative correlation (i.e., higher oil prices and lower stock prices, or lower oil prices and higher stock prices) is most evident on the days with the largest change in oil prices. However, as the list below indicates, even within these days showing the most extreme oil price movement, oil prices and stock prices move in the same direction as frequently as they move in opposite directions:

Date: % Change in Price of Oil vs. S&P 500

Days with Largest RISE in Price of Oil
01-Jun-2004: 6.1% vs. 0.0%
22-Feb-2005: 5.8% vs. -1.5%
15-Dec-2004: 5.7% vs. 0.2%
06-Jan-2005: 5.0% vs. 0.4%
19-Nov-2004: 4.8% vs. -1.1%

Days with Largest FALL in Price of Oil
01-Dec-2004: -7.4% vs. 1.5%
27-Dec-2004: -6.5% vs. -0.4%
02-Jun-2004: -5.6% vs. 0.3%
21-Apr-2004: -5.0% vs. 0.5%
02-Dec-2004: -4.9% vs. -0.1%

My sense of what is going on here is that when traders see oil prices rising, they sell stocks, and, similarly, traders buy stocks when oil prices fall. Essentially, the behavior of market participants, based on their pre-conceived notions of how markets are "supposed" to move, exacerbates market price movement itself--at least on an intra-day time scale.

I would guess that, in the longer run, this type of short-term momentum trading gets washed out by more fundamental economic forces, leading to a significantly weaker cause-and-effect relationship between oil prices and stock prices. I will take up this study using annual data in my next post.


Anonymous Penny stocks said...

I believe excessively high oil prices will affect stocks negavtively.

11:20 AM, October 24, 2011  

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