A large number of stories in the financial press this year have revolved around the relationship between equity prices and oil. In fact some commentators have focused on a recovering oil price as the key lynchpin for rising equity prices.
As an example, the Wall Street Journal published an article this year “Oil, Stocks at Tightest Correlation in 26 Years”. Many other publications and strategists have written pieces this year noting the close relationship between oil prices and equity index performance.
The human mind is conditioned to look for patterns and in the tumult of early 2016 the oil market meltdown started playing a leading role in explanations of why global equity markets were under stress. But as any econometrics professor will say “correlation is not causation“.
In this note we look at the sensitivity of asset class returns to changes in the price of oil. We take a risk management perspective and find that while oil price sensitivity is significant when analyzing one-on-one relationships, the effect is close to zero and statistically insignificant in a multivariate context.
What you see is not always what you get. We conclude that rising oil prices have little long-term significance for broad equity market prospects and that a rising oil price is more of a reflection of supply curtailment efforts.
The key lesson to us from our analysis is that commonly heard explanations for asset return drivers are often incomplete and in some cases highly misleading.
Every market environment has its own context and no single factor in isolation will ever be able to fully explain the complexities of market behavior. Even in hindsight it is often hard to pin down a story that holds up to serious scrutiny.
Best to stay humble and realize that over shorter time periods capital markets will always be subject to a lot of noise of no material significance to long-term investors.
Click here to download the report: Is It All About Oil
Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC