Sunday, November 4, 2012

Stock Markets and Oil Part I: The Volatile Relationship

Tracking The Stock Market and Oil
Lately, stock market volatility has been edging up and oil prices falling.  Oil prices, since the end of the official late-2000s recession, has closely followed the stock markets' movements.  Using the S&P 500 index as a measure of American stock markets and Brent oil as an indicator of world oil prices we can see the close relationship by dividing the index by the price of oil.
The S&P500/Oil divisor.  Daily S&P 500 index divided by daily Brent price in dollars ($).
Beginning in 1992 - after the early 1990s recession (and Iraq War) and the collapse of the Soviet Union - annual-average S&P 500 growth began to outpace oil prices.  The S&P 500 saw very large annual-average gains but oil prices lagged these gains.  The S&P500/Oil Divisor went from 20 in 1992 to 130 by late-1998/early-1999.

This relationship reversed course in 1999 when annual-average oil prices began to outpace the S&P 500.  At one point in late-1998 (in the wake of the Asian Financial Crisis and Russian sovereign debt default), oil was trading below $10 per barrel - ten years later in 2008 it would trade around $150 per barrel.  

Annual-average changes in Brent Oil (Red), S&P 500 (Black) and the S&P500/Oil Divisor (Green).
Prices Go Up, Prices Go Down
Slow increase or decline in oil prices can coincide with increased S&P 500 volatility. 

5-years of oil price (Red) and S&P 500 volatility (Blue).
However, because volatility is measured on a 3-month basis, oil prices do not necessarily lead changes in the stock market.  During the 2007-2008 financial crisis, the S&P 500 began its decline while oil prices were peaking - which then took a nose dive itself.  During the crisis, large investors began hedging risk with positions in gold and oil.  This was particularly true after two Bear Stearns hedge funds were liquidated in the summer of 2007 - essentially the beginning of the credit crisis.

S&P 500 (Black) and Oil (Red).

Plotting oil volatility alongside S&P 500 volatility reveals the close relationship.

S&P 500 volatility (blue), oil volatility (purple) and the S&P 500 index (black).
So what explains the current tight (inelastic) relationship between oil and the stock markets?  Peak Oil?  Slow growth?  The wealth effect?  Lack of easy credit?  Something outside America's control?

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