Why Oil Doesn't Move Stocks Anymore

For months, crude oil was caught in a vicious downtrend that looked like it would never end. That all changed in February, when prices began a surprising reversal. Now crude oil is in a steep uptrend, with prices steadily climbing day after day.

On Tuesday, Brent crude oil prices approached $50 a barrel for the first time in six months. That's a whopping 85% increase since prices bottomed at $27 earlier this year.

Anticipating further declines in U.S. crude oil production, most traders and analysts believe that the worst of the oil market glut has passed, and that the market will reach equilibrium sometime in the second half of the year.

This week, the Energy Information Administration reported that U.S. output dropped below 8.8 million barrels per day―800,000 barrels per day lower than where it was 10 months ago.

Brent Crude Oil Price Chart

Oil Rebound A Relief For Markets

The increase in crude oil prices has largely been welcomed by broader financial markets. Just as crude oil fell to its lows earlier this year, so too did the stock market. Similarly, as crude oil bounced back in March and April, so did equities.

In particular, energy stocks―one of the main sectors in the S&P 500―were walloped in January and February, only to come roaring back in subsequent months. Down as much as 14.2% in January, the Energy Select Sector SPDR Fund (XLE | A-90) is now up 10.3% year-to-date, the second-best performance of any sector.

But it wasn't just energy stocks influencing the broader stock market. High-yield corporate bonds were hit hard as oil fell to its depths on concerns that default levels would rise as energy companies (which were heavy issuers of junk debt) would be unable to make interest payments.

Fears of an energy-led junk bond crisis reached fever pitch in January and February, only to fade as oil rebounded.

The iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) was down as much as 5.7% in January, and is now up 5.3% year-to-date on a total return basis.

YTD Returns For XLE, HYG, Front-Month Oil

Correlations Weakening

The strong bond between oil and other asset classes was something I noted in an ETF.com article in February.

At the time, the 30-day correlation between the SPDR S&P 500 (SPY | A-97) and front-month oil futures reached more than 0.6, the highest level in three years (a correlation of +1 means the two always move in the same direction, while a correlation of -1 means the two always move in opposite directions). Likewise, the correlation between oil and HYG reached a robust 0.85.

Those strong correlations maintained themselves for a while, but they've since weakened notably. Indeed, even a casual look at recent market action reveals that oil hasn't been the driver of markets that it used to be.

On Tuesday, the stock market dropped 1% at the same time that oil hit its highest level in half a year. Even the junk bond ETF, HYG, lost 0.2% on the day.

The latest correlation figures tell the same story. The 30-day correlation between SPY and front-month oil futures is now a mere 0.22 and fell as low as 0.14 earlier this month―the weakest level in nearly a year.

30-Day Rolling Correlation For Oil Futures & SPY

Even the correlation between oil and junk bonds has weakened to 0.59.

Oil In The Sweet Spot

The reason for the weakening in the tie between oil and other markets is simple. As I wrote in the February article, " … at some point, oil will cease to be the driving force of the stock and junk bond markets. When that happens is anyone's guess, but it will probably take place when the oil-induced stress on the markets is alleviated."

With oil's near-doubling off its bottom, that stress has largely been alleviated; hence the decline in correlations.

In fact, if oil gets high enough, stocks could actually be pushed lower on concerns about high fuel prices and inflation―but that's another story. For now, oil seems to be in the sweet spot where neither consumers, producers nor investors need worry too much.

At the time of writing, the author held no positions in the securities mentioned. Contact Sumit Roy at [email protected].