In a post from the end of 2014, Hamilton proposed estimating an equation relating changes in oil prices to changes in copper prices, changes in the ten-year Treasury interest rate, and changes in the dollar, then using the value of the oil price predicted by that equation to measure the effect of demand shifts on the oil market. For a simple test of that hypothesis, we apply a decomposition suggested by James Hamilton, a macroeconomist and expert in oil markets at the University of California-San Diego. Interestingly, although the correlation has ticked up in the past few months, it has not been unusually high recently, compared to the rest of the five-year sample.Īs we mentioned earlier, the positive correlation of stocks and oil might arise because both are responding to underlying shifts in global demand.

On average, however, the correlation is positive (stocks and oil move in the same direction). In other words, sometimes the prices of stocks and oil move in the same direction, sometimes in opposite directions. The impression from Figure 2 is that the relationship between stocks and oil is itself volatile, with the correlation between the returns to stocks and to oil swinging between positive and negative values. To capture short-term variations, we estimated correlations using a rolling window of 20 business days. Using daily data, my research assistant Peter Olson and I calculated those correlations for the past five years (Figure 2 below). To set the stage, let’s look at the raw correlations of (the percentage changes in) stocks and oil prices. However, even with these two factors included, a significant part of the oil-stocks correlation remains unexplained. We find that an underlying demand factor does account for much of the positive relationship, and that if, in addition, we account for shifts in market risk preferences, we can explain still more.

We then investigate the hypothesis that underlying changes in aggregate demand explain the oil-stocks relationship. In this post we first confirm the positive correlation between stocks and oil prices, noting that it is not just a recent phenomenon. As a recent Wall Street Journal article put it: “Oil and stock markets have moved in lockstep this year, a rare coupling that highlights fears about global economic growth.” One plausible explanation of the tendency for stocks and oil prices to move together is that both are reacting to a common factor, namely, a softening of global aggregate demand, which hurts both corporate profits and demand for oil.

The usual presumption is that a decline in oil prices is good news for the economy, at least for net oil importers like the United States and China. On the surface, the tendency for stocks to fall along with oil prices is surprising. Stock prices have also been falling recently, and these moves have generally followed the course of oil prices, a development much commented on by the financial press (for example, see here and here). The second may still be going on: Oil prices have fallen from over $100 per barrel in mid-2014 to around $30 per barrel recently. One crash, in 2008, was associated with the financial crisis and the Great Recession. The period includes much volatility and two sharp crashes. The past decade has been a roller coaster for oil prices, one that market participants have probably not much enjoyed riding (Figure 1).

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