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):

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