Why The Correlation Between Oil Prices and the Stock Market is Important

In a world of record highs nearly everywhere you look, one asset remains left behind firmly in the doldrums.

Given its importance, this is somewhat surprising.

I’m talking about oil of course. The literal and figurative lubricator of the global economy.

The old theory was that the market and the oil price were highly correlated. Where the market went, oil would surely follow.

Which makes sense.

As a gauge of economic activity, it’s perfectly reasonable to suppose that when the economy was on the up, demand for energy and thus oil would rise too.

And vice versa when the economy splutters and markets fall.

But — as I’ll show shortly — in 2014, this changed.

Why this happened and what happens next are important.

Let me explain…

The jaws of opportunity?

Take a look at the 12 year chart of NYMEX WTI oil versus the S&P 500 index of top US stocks:

12 year chart of NYMEX WTI oil versus the S&P 500 index of top US stocks 2-11-17

Source: Incredible Charts

[Click to open new window]

In 2014 the stock market rocketed on to new highs, while oil prices fell to lower than GFC levels.

The chart now resembles a crocodile laying with its jaws wide open. Could it be set to snap shut?

As tends to happen, mainstream media only started writing about this very late in the process. At the end of the trend.

Market Watch noted in April of 2016 that the correlation between the stock market and oil prices was fading.

Forbes came out in February 2016 with an analysis on why the correlation between the stock market and oil prices varies.

By that point oil had clearly bottomed out.

The lesson here is don’t wait to read about it in the mainstream to find out what’s happening. Not if you want to profit form it anyway…

There’s numerous reason for the steep 2014 oil price fall.

From a slowdown in Chinese growth and the general emerging markets trend — the so called BRIC economies. To the increase in US oil through new fracking technologies created in an era of high prices. To the rise of electric cars…

There’s even some conspiracy theories that the low prices were intended to shut down the US shale industry. A Saudi-led plot.

All played a part for sure (I’m not so sure about the last one, though). 

Risk on, risk off

But I think another reason is the most interesting.

Because it will help you analyse what happens next. It doesn’t really need you to create some fancy supply-demand model of oil prices. Or try to guess what’s going to drive one nor the other.

You see, it’s a psychological element that’s been a feature of oil for decades.

It’s like this…

The correlation between the stock market and oil prices is usually very high. And in my opinion this is likely to remain for the next few decades, despite advances in alternative energy sources.

As I said at the start, it’s a logical consequence of economic activity.

This correlation is strong. It’s only broken down twice in 10 years. But both times that it diverged, the divergence was very strong.

Interestingly, the divergences took place during ‘risk off’ times. These are times when the economy is faltering. In 2008, stocks led the decline, while crude oil did so in 2014.

So in ‘normal’ times, the correlation between the stock market and oil prices is very high.

If stocks and oil prices do indeed have a strong correlation during ‘risk on’ times, then that is when they tend to move in sync.

As markets are now clearly in a risk on mode, oil prices are likely to become more attractive to investors.

You won’t hear about it in the papers until it’s clearly happening.

But I think as oil reaches a crucial break point at US$60, investors should be keeping a close eye on what happens next.

If it breaks and the markets remain buoyant, this could be the start of big move up for oil.

Good investing,

Ryan Dinse,
Editor, Money Morning

PS: Our Head of Research Greg Canavan was tipping a potential oil price break months ago. Read his reasons why 2018 could be a particularly big year for oil. And how you can profit. Click here for more info…

Ryan Dinse is an Editor at Money Morning.

He has worked in finance and investing for the past two decades as a financial planner, senior credit analyst, equity trader and fintech entrepreneur.

With an academic background in economics, he believes that the key to making good investments is investing appropriately at each stage of the economic cycle.

Different market conditions provide different opportunities. Ryan combines fundamental, technical and economic analysis with the goal of making sure you are in the right investments at the right time.

Ryan's premium publications include:

Money Morning Australia