Why Stocks & Oil Are Correlated

Down in the morning, crude oil staged a strong comeback to end higher on the session Wednesday, Feb. 24. U.S. stocks―also down in the morning―embarked on a furious comeback of their own to finish that day up.

Anyone who’s been paying attention knows that the oil-stock market connection on Wednesday wasn't a one-day affair: It's been a recurring pattern for months, with the tie between the two only intensifying in early 2016.

Is this phenomenon unusual?

Strong Correlation Not Unusual

First, let's put the current situation into numbers. The 30-day correlation between the SPDR S&P 500 ETF (SPY | A-98) and front-month West Texas Intermediate (WTI) crude oil futures is 0.61, the highest level since 2013 (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).

During the past decade, there have been long periods of time when oil and stocks were as highly correlated or even more correlated than they are now. From mid-2008 to the end of 2010―the period that encompassed the financial crisis and its aftermath―the two were tied at the hip with the 30-day correlation reaching as high as 0.8.

30-Day Rolling Correlation For Oil Futures & SPY

Then from mid-2011 to mid-2013, the oil-stock market correlation strengthened to those levels again.

Of course, as the old saying goes, correlation is not causation. Just because the two are moving in tandem doesn't necessarily mean one is driving the other.

For example, during the 2008-to-2010 period, it was obviously the Great Recession and the subsequent recovery that drove oil and stocks to move in lockstep.

Oil The Driver

What makes the current period unique is that it seems as if oil is driving the stock market rather than the two being influenced by external factors.

From a fundamental perspective, that assumption makes sense. Oil's demise is responsible for the majority of the woes afflicting the economy and markets currently.

Oil's impact has been three-pronged, with the decline in prices raising risk in earnings, economic and credit in the U.S. and abroad.

Lower crude oil prices reduced aggregate earnings for companies in the S&P 500 by more than 6% in 2015; lower crude oil prices have hammered the economies of many major oil-producing countries; and lower crude oil prices fueled a spike in credit spreads in the U.S.

It's no wonder the correlation between oil and the stock market is currently so tight, with the former seemingly leading the latter on a day-to-day basis.

Bonds Impacted Too

It's not just the stock market that's taking its cues from oil. Bonds are too―specifically, high-yield bonds.

The 30-day correlation between front-month crude and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-68) is a robust 0.85, essentially matching the two prior peaks in 2009 and 2011.

30-Day Rolling Correlation For Oil Futures & HYG

Again, what makes the current situation different is that oil is clearly driving junk bonds, which makes sense given the heavy weighting of energy in the high-yield space.

Pattern Will Continue

Of course, 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.

The easiest way for that to happen is for crude oil to rebound to higher levels. Otherwise, the financial system must absorb all the short-term negative repercussions from oil at current prices or lower―the bankruptcies, the junk bond defaults, the hit to corporate earnings, the lower growth in emerging markets―before the correlation breaks.

In either case, oil is likely to be the key driving force of financial markets for at least the next few months, if not longer.

Contact Sumit Roy at [email protected].