When Crude Prices Rise, Equities Suffer

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Even with the best tools, trying to discern the exact time when equities will rise or fall is a tough job. A new study may give advisors a leg up on the process.

“Striking Oil: Another Puzzle,” by Gerben Driesprong, Ben Jacobsen, and Benjamin Maat of the Rotterdam School of Management, concludes that oil prices strongly predict future stock market returns in most countries. The results seem to hold up during different time periods, yielding results that are more significant than those gained from other timing methods. Perhaps more interesting, buy and sell signals from crude prices seem to be getting more robust over time.

According to Dreispong’s work, a considerable amount of research has been performed on the effects of oil shocks on the global economy. However, few have looked at how oil prices themselves have impacted stocks, probably because of the short amount of time energy products have been freely traded.

The study examined stock returns from 48 countries and the MSCI World Market index. Data was examined from the beginning of the Yom Kippur War in October 1973, since before then oil prices were effectively stabilized by the major oil companies.

The results showed that if oil prices rise in a given month, stock prices tend to fall in the next month. Similarly, lower oil prices are typically followed by higher equity prices. Moreover, the impact of changes in the oil price on stocks tended to be large. For instance, a decrease of the oil price of 10% doubled the expected return of the U.S. stock market in the next month.

Although Dreispong’s work was designed to be a general indicator rather than a precise entry and exit tool, there will be those who choose to use his research to dynamically adjust market exposure. Besides the usual implementation issues that would arise from such an attempt, traders will also have to determine if the relationship between energy and equity prices will remain stable over time.

Unfortunately, oil prices aren’t portending a pleasant start for the fourth quarter, as crude prices rallied an astonishing 20% during the month of September to all-time highs.