Just How Correlated Are Oil and Equities?

by: Jeff Pietsch August 14, 2008 | about stocks: DIA / OIL / SPY / USO    

Jeff Pietsch

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Am I the only one tired of hearing about the correlation between Oil and US Equities? Certainly that has been quite the trade, and there is obviously a fundamental connection between the two that goes beyond the US Dollar, but all the TV talk and loose use of the term "correlation" had me wondering just how strong the relationship has been from a bar-to-bar statistical standpoint.

As this article will point out, over the long run the relationship has been less than one might assume from all of the talk.

Causal or Casual Relationship?

The inverse relationship between Oil and the S&P 500 certainly seems readily apparent, just look at the chart of the United States Oil (USO) versus S&P500 Spider (SPY) ETFs over the last ten-days:


But, statistically, are we being fooled by the recency effect of this fresh observation? Take a look at the longer-term six-month chart of the same ETFs below:

The market is clearly sensitive to oil, and suffered as it posted its sixty percent gain, but did the market decline sixty percent? How about forty? Has it recovered twenty percent as oil has fallen by the same relative amount? Clearly not. Even after considering the moderating energy component of the index, the statistical relationship on the broader market is considerably weaker than some may lead us to believe from their casual commentary. But how much so?

Just the Stats Ma'am

As shown in the chart below entitled 1-Day Rolling Correlation, over the last ten days, while there was obviously an inverse directional relationship between the indices, there was really only one when when the rolling correlation exceeded |70%|:

In fact, over the 790 five-minute bars constituting that ten-day period, there was only a -31.6% bar-to-bar correlation. Furthermore, over a longer two-year period using 20-day rolling correlations (20-Day Rolling Correlation), there was actually only one brief period late last July when such a significant statistical correlation occurred. Over the entirety of that period there was no measurable correlation (r=-0.8%). If anything, historically there appears to have been a positive regime bias to the relationship!

So what's all the hoopla about! Well, again there is the recency effect of the last several weeks, and crude oil near USD $150 per barrel will undoubtedly be etched in our collective conscious for some time to come.

More significantly, while the relationship may be dicey on a bar-to-bar statistical basis, during the last 20-days, 70% of the time the two indices did in-fact close in opposite directions (Ratio of Inverse Closing Changes), confirming our intuitive - if statistically incorrect - observation.

The real question going forward, of course, is how much longer this connection will play out? Tracking the rolling correlation and ratio of inverse closes between the two may help you to answer this question.

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This article has 14 comments:

  •  
    Aug 14 02:10 AM
    Excellent! Good to see someone doing the statistical work instead of just listening to blowhards.
    Reply | Link to Comment
  •  
    Aug 14 02:42 AM
    Great piece. This is a question not enough folks are answering.
    Reply | Link to Comment
  •  
    Aug 14 09:29 AM
    Why did you not include the 1970's data in your work?
    The price of oil is the single biggest economic factor in the US considering we import 70% of it. The rise in oil of the past decade is the single biggest reason the S&P has averaged an enemic 2.8% annual return during that time.
    Reply | Link to Comment
  •  
    Aug 14 09:32 AM
    Good article, Jeff.

    How about a similar look at the relationship between the USD and crude oil? The talking heads constantly insist that there's a causal effect between dollar relative movement and crude. (It makes them sound smart to repeat something they've heard.)

    I think it could just as well be argued that the higher price of oil negatively affects the US economy, which in turn influences the currency. In any case, it's certainly not a proportional relationship.
    Reply | Link to Comment
  •  
    Aug 14 09:53 AM
    Want to be a loser in markets, use statisticst extrapolate or correlate. The physical science don't work in the social sciences and Wall Street has been conned by academia for decades with this voodoo. Ask the geniuses at LTCM! Sorry, but you still have to do fundamental research. Some even do primary along with secondary, but most analysts want their computers to do all the work.
    Reply | Link to Comment
  •  
    Aug 14 10:11 AM
    The Fitzman - no, the single biggest reason for the anemic return of the SP500 over the past decade is the unprecedented, huge return of the SP500 over the decade before that.

    It rose at 25% annual rates in much of the 1990s. That wasn't remotely a sustainable pace. It was a bubble. The periods that matter for long term real stock valuation swings are on the scale of 15 years or so. It takes that long to wring out the effects of the last uber-bull.

    Much of that wringing out happens in the immediately following bear market, over the course of just a couple of years. But the previous peak won't be permanently surpassed again for a much longer time period.

    We see this in 2000 and its aftermath, we see it in the 1960 megabull and its early 70s immediate aftermath (it isn't until the early 80s that it fully ends), we see it in the aftermath of the 1920s bull, which is smashed by 1932, but not recovered from fully until after WW II.

    Oil is somewhat correlated with the following periods of difficulty - strong in the 1970s and the present decade. Monetary inflation and currency weakness are driving much of that.
    Reply | Link to Comment
  •  
    Aug 14 10:50 AM
    Your graphs are useless. Common sense tells you that if oil goes down that is like getting a huge tax cut or stimulus package. To say they are not correlated makes no sense.
    Reply | Link to Comment
  •  
    Aug 14 11:15 AM
    The stats can be deceptive because of the market inefficiencies. When the oil goes up, your local gas stations are raising the prices immediately, but are they reducing it as fast and proportionately when oil goes down? No. So, the net effect is that the future holder speculators are making the money, but the broader economy is not highly correlated to the benefits. So, the stats will be skewed in one direction.
    Reply | Link to Comment
  •  
    Aug 14 11:47 AM
    Nice article, it might be worth testing if there is a lagged correlation rather than bar-to-bar. After all you might expect it to take 6 months for the immediate impact of an oil price hike.
    Reply | Link to Comment
  •  
    Aug 14 11:50 AM
    Doesn't the S&P now consists of many energy firms. I know the Circuit City was cut out of it and replaced by some energy company. If this is the case, it wouldn't be statistically fair. Why don't you pick a broad range of company i.e. Starbucks, Intel, Walmart, etc. and see what happen?
    Reply | Link to Comment
  •  
    Aug 14 12:09 PM
    Nice start!. I would like to see a stock like CNQ as the dependent variable with CL, DJIA as independents. What would the r-squared coefficients look like? Have often wondered...
    Reply | Link to Comment
  •  
    Aug 14 12:29 PM
    ...very interesting article and some great comments!

    Arsuron brings up a great point. While the S&P500 does constitute an appropriate benchmark, the names are changed periodically to specifically reduce volatility and attempting to mirror the current state of the US economy in terms of aggregate business performance.

    Also, while no experiment or analysis of correlation can be perfect, I would argue that a single correlation figure is irrelevant when examining the price of oil and its affect on the broad US economy. about 3/4 of oil's demand in the US comes from gasoline, which - at the retail level - does not move as freely as oil. Rising oil prices lead to rising gasoline prices at a slightly-lagging pace; however, falling oil leads to falling gasoline prices at a much slower pace. I don't have any specific data for this, but it would be very interesting to see.

    Logically, more money spent on oil means higher expenses for most US businesses and less disposable income for US consumers. Both of these things will absolutely lead to a worse economy, ceteris paribus.


    Cheers
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  •  
    Aug 15 12:51 AM
    44 of the largest oil fields in the world are in serious decline. When lack of supply finally starts to effect the price of oil in a serious manner those sectors of the economy that are hyper sensitive to the price of energy, like autos and airlines, will bring the economy and the market to their Knees. This will prove that economy is connected to equities, big time.
    Reply | Link to Comment
  •  
    Aug 15 05:11 PM
    mission of russian army in georgia is to control (shut off when it will do the most damage) the supply of oil to ceyhan in order to hold european nations hostage.
    > jack
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