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Mark Hulbert: Using oil prices to time the stock market is a strategy that’s running on empty

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It may or may not be good news for the stock market that oil’s
CL00,
+1.28%

price is currently 40% lower than where it traded this past June. This counters the conventional wisdom that a lower oil price is good for stocks. In some past cases it was, but in others it clearly was not.

This is illustrated in the chart below, which plots the trailing 36-month correlation coefficient of monthly percentage changes in the S&P 500
SPX,
-0.38%

and West Texas Intermediate crude.
WBS00,
+1.26%
.
This coefficient ranges from a theoretical maximum of 1.0 (which would mean that stocks and oil are perfectly correlated, with both moving up and down in lockstep with each other) to a theoretical minimum of minus 1.0 (which would mean that the two move inversely to each other, with one zigging every time the other zagged, and vice versa).

Notice that there have been occasions since the early 1970s when this coefficient has been above 0.6, and other times when it has been below minus 0.6. The overall relationship over the past five decades is anything but stable. I reached similar conclusions when measuring oil’s track record as a leading indicator rather than, as the chart does, a coincident indicator.

By no means do these results signify that oil’s price is unimportant. Instead, the point of the chart is that there is no simple or mechanical way of using oil’s price to time the market.

Why the oil-stock correlation is unstable

There are many reasons why oil has such an unstable relationship to the stock market. But one of the more important is that the relationship depends on whether the market is more preoccupied with inflation or deflation. When the preoccupation is inflation, then a higher oil price is a negative. But when investors are more worried about economic weakness that manifests in lower prices, a higher oil price indicates that the economy is stronger than previously thought — and therefore a good thing.

Right now, for example, given the markets’ obsession with inflation, oil’s price decline is probably more good news than bad. In contrast, at other times when investors are more worried about outright deflation, then a declining oil price is a cause for concern. An illustration is what happened over the last half of 2008, when West Texas Crude Oil fell 68.1% and the S&P 500 fell 29.4%.

In order to translate oil’s price changes into a market-timing indicator, you would first need to know investors’ primary preoccupations and, as well, when they may become preoccupied by something else. Good luck with that. This reinforces what Yale University finance professor Robert Shiller focused on in his recent book entitled “Narrative Economics: How Stories Help Drive Economic Events.”

Another reason for the unstable oil-stock relationship, according to a study published this summer, is the market’s transition from treating oil primarily as a physical commodity to a financial asset. This transition, which the study’s authors refer to as “oil financialization,” traces to developments in the derivatives market and to regulatory changes. They date this transition to the early 2000s.

The study, entitled “Good oil volatility, bad oil volatility, and stock return predictability,” appeared in the July 2022 issue of the International Review of Economics & Finance. The authors, Jihong Xiao and Yudong Wang of the School of Economics and Management at China’s Nanjing University of Science and Technology, write that, because of oil financialization, “a large amount of capital from various investors, such as hedge funds, pension funds, and speculators, flows into the oil market, driving the financial boom of the oil market…As a result, … oil has become an important asset allocation as a financial asset for investors.” This in turn led to significant changes in the correlation between oil and the financial markets.

The bottom line? The oil-stock relationship is far too complex to be useful in any simple market-timing model.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]

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