Researchers at the Federal Reserve Bank of Cleveland looked at movements in the price of oil and stock market prices and discovered, to the surprise of many, that there is little correlation between oil prices and the stock market. Their study does not necessarily prove that the price of oil has a very limited impact on stock market prices; it does suggest, however, that analysts cannot really predict the way stocks react to changing oil prices.
It is popular to correlate changes in major factor prices, such as oil, and the performance of major stock market indexes. Conventional wisdom holds that an increase in oil prices will raise input costs for most businesses and force consumers to spend more money on gasoline, thereby reducing the corporate earnings of other businesses. The opposite should be true when oil prices fall.
Andrea Pescatori, an economist at the International Monetary Fund (IMF), attempted to test this theory in 2008. Pescatori measured changes in the S&P 500 as a proxy for stock prices and crude oil prices. He discovered his variables only occasionally moved in the same direction at the same time, but even then, the relationship was weak. His sample revealed that no correlation exists with a confidence level of 95%.
Why Oil Does Not Really Drive Stock Prices
So why can't Fed economists find a stronger correlation between the stock market and oil prices? There are several likely explanations. The first and most obvious is that other price factors in the economy, such as wages, interest rates, industrial metals, plastic and computer technology, can offset changes in energy costs. Another possibility is that corporations have become increasingly sophisticated at reading futures markets and are better able to anticipate shifts in factor prices; a firm should be able to switch production processes to compensate for added fuel costs. Some economists suggest that general stock prices often rise on the expectation of an increase in the quantity of money, which occurs independently of oil prices.
A distinction needs to be drawn between the primary drivers of oil prices and the drivers of corporate stock prices. Oil prices are determined by the supply and demand for petroleum-based products. During an economic expansion, prices might rise as a result of increased consumption; they might also fall as a result of increased production.
Stock prices rise and fall based on future corporate earnings reports, intrinsic values, investor risk tolerances and a large number of other factors. Even though stock prices are commonly aggregated and lumped together, it is very possible that oil prices affect certain sectors much more dramatically than they affect others. In other words, the economy is too complex to expect one commodity to drive all business activity in a predictable way.
Oil Prices and Transportation
One sector of the stock market is strongly correlated with the spot price of oil: transportation. This makes sense because the dominant input cost for transportation firms is fuel. Investors might want to consider shorting the stocks of corporate transportation companies when oil prices are high. Conversely, it makes sense to buy when oil prices are low.