From Mr. Bernanke's blog at Brookings:
The past decade has been a roller coaster for oil prices, one that market participants have probably not much enjoyed riding (Figure 1). The period includes much volatility and two sharp crashes. One crash, in 2008, was associated with the financial crisis and the Great Recession. The second may still be going on: Oil prices have fallen from over $100 per barrel in mid-2014 to around $30 per barrel recently.
Stock prices have also been falling recently, and these moves have generally followed the course of oil prices, a development much commented on by the financial press (for example, see here and here). On the surface, the tendency for stocks to fall along with oil prices is surprising. The usual presumption is that a decline in oil prices is good news for the economy, at least for net oil importers like the United States and China.[1]
One plausible explanation of the tendency for stocks and oil prices to move together is that both are reacting to a common factor, namely, a softening of global aggregate demand, which hurts both corporate profits and demand for oil. As a recent Wall Street Journal article put it: “Oil and stock markets have moved in lockstep this year, a rare coupling that highlights fears about global economic growth.”
In this post we first confirm the positive correlation between stocks and oil prices, noting that it is not just a recent phenomenon. We then investigate the hypothesis that underlying changes in aggregate demand explain the oil-stocks relationship. We find that an underlying demand factor does account for much of the positive relationship, and that if, in addition, we account for shifts in market risk preferences, we can explain still more. However, even with these two factors included, a significant part of the oil-stocks correlation remains unexplained.
To set the stage, let’s look at the raw correlations of (the percentage changes in) stocks and oil prices. Using daily data, my research assistant Peter Olson and I calculated those correlations for the past five years (Figure 2 below). To capture short-term variations, we estimated correlations using a rolling window of 20 business days.
The impression from Figure 2 is that the relationship between stocks and oil is itself volatile, with the correlation between the returns to stocks and to oil swinging between positive and negative values. In other words, sometimes the prices of stocks and oil move in the same direction, sometimes in opposite directions. On average, however, the correlation is positive (stocks and oil move in the same direction). Interestingly, although the correlation has ticked up in the past few months, it has not been unusually high recently, compared to the rest of the five-year sample....MORE
