Oil and Stocks: The “Correlation”

Historically, oil prices and stock prices were negatively correlated, or exhibited a close to zero correlation.  During the financial crisis, the equity-oil correlation spiked.  In recent weeks, it has plunged, and become sharply negative.

Some people try too hard to explain this pattern.  To me it has little to do with QEII, and the explanation is relatively simple.  It depends on what are the important shocks at any particular time.  When macro demand shocks predominate, correlations will be positive; when oil supply shocks are important, correlations will be negative.

During the financial crisis, there was slack oil production capacity, and price movements were demand driven.  Prices plummeted when demand crashed in the post-Lehman days.  Prices rebounded when economies around the world started to recover.  The economic crash and recovery drove stock prices lower then higher.  So during the crisis and recovery period, the state of the macroeconomy drove oil demand, and drove stock prices and oil prices in the same direction.

In contrast, the Mideast turmoil has generated oil supply shocks.  Declines in oil output, and increased likelihood of greater future output declines cause oil prices to go up.  These output declines also tend to reduce economic growth, and if severe enough, can tip economies into recession.  Thus, these adverse output shocks tend to cause stock price declines  because stock prices reflect the health of the broader economy.

In brief, the historically high positive correlation between oil and stock prices during the late-2008-early-2010 period reflected the fact that the primary shocks driving both markets during that period were macro shocks that influenced the demand for oil.  The negative correlation we observe now is due to the fact that the predominant shocks are oil supply shocks that will adversely affect the real economy.

The title of the FTAlphaville piece I linked to asks whether the correlation breakdown is “permanent.”  I permanently wonder why people have a tendency to believe that the most recent change will last forever.  No, the correlation shift is not permanent.  When supply shocks abate, and when (macro) demand shocks intensify, the correlation will tack again.