Earlier today, I talked about the recent decline in oil prices, discussed here. I thought I would provide some deeper analysis on the connection of oil prices and the broader equity markets. The following two charts show the 13-week percentage change of the S&P 500 versus light sweet crude since 2000 and the 1-year correlation of the said returns over the same time frame.
Generally speaking and prior to 2008, the price of oil and the S&P 500 have moved in opposite directions, with some periods punctuated by a slightly positive correlation. In 2008 however, the correlation jumped significantly. This level of return correlation was never once seen since, at least, the early 80's, noting that prior to 2008 the highest 1-year correlation was 69% back in 1986. If you look closely, this dynamic can also be seen on the rolling 13-week performance chart, as the performance figures for the equity markets and oil began to align in 2008. Presently, the correlation between the two is 80%.
What accounts for this? My thoughts are that it is the manipulation of the money supply by the Fed and the knock on affect of inflation expectations. I am thinking that the the high correlation in 2008 is a function of the bear market, when all asset classes sold off, except for the safe-haven U.S. treasuries. This thesis fits with the historical record, as declines in the equity markets look to coincide with a rising oil correlation. Since 2008 however, the historical relationship appears to have turned on its head. A decline in the correlation foreshadowed a decline in the market in March 2010 and July 2011. The correlations subsequently increased following these periods. Why? My guess is that it was monetary stimulus or the expectation there of, as both QE2 and operation twist 2 were announced and enacted shortly there after each period. Unless the recent relationship will break down, which may be doubtful considering QE to infinity, the decline in oil may suggest that the equity markets may act in kind.
Generally speaking and prior to 2008, the price of oil and the S&P 500 have moved in opposite directions, with some periods punctuated by a slightly positive correlation. In 2008 however, the correlation jumped significantly. This level of return correlation was never once seen since, at least, the early 80's, noting that prior to 2008 the highest 1-year correlation was 69% back in 1986. If you look closely, this dynamic can also be seen on the rolling 13-week performance chart, as the performance figures for the equity markets and oil began to align in 2008. Presently, the correlation between the two is 80%.
What accounts for this? My thoughts are that it is the manipulation of the money supply by the Fed and the knock on affect of inflation expectations. I am thinking that the the high correlation in 2008 is a function of the bear market, when all asset classes sold off, except for the safe-haven U.S. treasuries. This thesis fits with the historical record, as declines in the equity markets look to coincide with a rising oil correlation. Since 2008 however, the historical relationship appears to have turned on its head. A decline in the correlation foreshadowed a decline in the market in March 2010 and July 2011. The correlations subsequently increased following these periods. Why? My guess is that it was monetary stimulus or the expectation there of, as both QE2 and operation twist 2 were announced and enacted shortly there after each period. Unless the recent relationship will break down, which may be doubtful considering QE to infinity, the decline in oil may suggest that the equity markets may act in kind.
No comments:
Post a Comment