3 reasons not to rely on the S&P500/oil price relation – January 25

There are many analysts who consider crude oil price as a good indictor for changes in the stock market trend such as the S&P500.

There are three reasons to question this paradigm:

  1. Low correlation: if you consider the monthly percent changes of crude oil price and S&P500 you will see that there is merely a 14.8% correlation between the two.

In the following graph is the S&P 500 and oil normalized prices, in which 100=January 1998. The chart doesn’t show any apparent relation between the two. This is probably because each index has different variables that affect them.

crude oil price chart & S&p500 1998-2010

2.       Inconsistence correlation: even if you might consider a nearly 15% correlation as “good enough”, you will be surprised to notice that the relation between crude oil price and S&P 500 (M-2-M percent change) isn’t consistent: in the following chart is the level of correlation M-2-M percent change broken down into years. The chart shows that during 2003-2006 there was a strong negative correlation, while during recent years (2007-2010) there was a strong positive correlation. Despite the recent strong correlation, it could easily switch back into a negative one, and therefore it wouldn’t be prudent to rely on it.

crude oil price correlation with S&p500 1999-2010

3. Level of Volatility: In the crude oil price and S&P500 chart above there is no apparent trend between the two. Furthermore, each index has different volatility: crude oil price M-2-M percent change std. is 8.8% during 1998-2010, while S&P500 std. is 4.2%, i.e. nearly half the volatility. Therefore, relying on an index (crude oil price), which is nearly twice as volatile as the other index (S&P500), which you want to predict, doesn’t coincide.

I think that we will need to rely only on correlations that proven to be consistent and series that are similar to one another before we can make speculative inferences.

For further reading (in this site):

2 comments for “3 reasons not to rely on the S&P500/oil price relation – January 25

  1. katie
    March 7, 2011 at 2:13 pm

    Why has the price of oil changed between 2010 and the beginning of 2011? Please can you help me, as this is for my course work in GCSE Business studies.

    • admin
      March 7, 2011 at 6:37 pm

      Hi Katie,

      Let me offer you some suggestions for this recent rise in crude oil prices, from my point of view: for one thing there is the whole turmoil in the Middle East which is a major contributing factor to the uncertainty level in that region and thus the uncertainty of the oil market. As the uncertainty rises the fluctuations of oil prices also tend to increase.

      There are also additional factors to consider such as the tightness of the European oil market in recent times: as the oil stocks in many Euro countries fall, and the demand during winter rise (after all January is the middle of winter) any increase in demand is more price sensitive because there is less fuel to go around. How did Europe come to such a condition? There are ample reasons, such as the harsh winter (more than in the past) increased demand for heating purposes more than expected, supply problems of Brent oil (Norway); and there is also the increase in demand in China that raised the price pressure for crude oil. Finally, since there are many traders who fear an outbreak in inflation, many traders stock up and buy commodities such as gold and oil and prepare for the future.

      Hope this helped,

      Good luck


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