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For many months now I have been hearing and reading various experts and market commentators state that the rising price of oil (and other commodities) is the reason for the bull market in equities which began in September/October of 2010. The recent pullback of the stock market is also being explained away as the result of the recent oil price retracement. As the rationalization goes, traders seeing the price of oil reversing below the $100 mark several weeks ago concluded that a global economy slowdown must be in the works, and this led the equity markets to correct.

In my opinion, the above mentioned experts confuse the cause and the effect in this situation. Yes, the price of oil has been in an uptrend (especially in 2011) and this has roughly coincided with the uptrend in the equity markets. But simply because 2 events are happening around the same time does not prove that one is causing the other. The reality is quite different. Both the rising oil prices and stock prices are the result of the depreciation of the US dollar.

First of all, the very idea that high oil prices can be good for the economy is absurd. Admittedly, the Oil Services Industry has done very well. However, many other industries (airlines, truckers, shippers, couriers being the most obvious ones) have been hurt. High oil prices squeeze corporate margins and simultaneously cause the consumers to spend a larger portion of their income on gas, leaving less money for everything else. Small wonder that the market leaders for the past year have been companies like Amazon (AMZN), Apple (AAPL) and Netflix (NFLX) - all businesses for which the price of oil is immaterial.

And how closely correlated are the price of oil and the stock market really? In the following graph (courtesy of assetcorrelation.com), the S&P 500 Futures (SPY) are compared to the price of crude oil (USO). For those readers not familiar with correlations: a value of 1 would mean that two assets are identical. The NASDAQ Composite and the S&P 500 for example have a correlation of 0.97. A value of negative 1 would mean that the assets move in the exact opposite direction - for every 1% one asset goes up, the other asset will go down by the exact 1%.

As you can see, at the end of 2010 and first quarter of 2011, the correlation between oil and the stock market was slightly negative (an average correlation of approx. (--0.2). Starting in mid March, the correlation became slightly positive, but the average value is about zero (i.e. no correlation) for the 6 month period tested.

click to enlarge
Correlation Between Oil prices (<a href='http://seekingalpha.com/symbol/uso' title='The United States Oil ETF, LP'>USO</a>) and Stock Market (<a href='http://seekingalpha.com/symbol/spy' title='SPDR S&P 500 Trust ETF'>SPY</a>)

The above graph shows there is very little correlation between oil and the stock market. Now let's review how the stock market actually reacts (if at all) when oil price makes a big move up or down for its own oil-specific reasons. The chart below is a comparison of crude oil price (represented by the OIL ETF) vs. the S&P 500 Index. The daily candlestick chart is OIL, and the red line is the S&P.

Comparison Chart OIL vs. S&P 500

At the end of 2010, the two assets were both climbing up. However, starting in mid/late January OIL went into a correction, while the 500 continued moving higher. The assets continued to move in the opposite direction until February 15 - the day the unrest began in Libya. Over the weekend and the following week, concerns about the supply of crude oil (Libya is a major oil producer) sent the price of OIL up 15% (see circled area of chart). According to the proponents of the oil-fueled bull market in equities, this explosion of oil prices should have provided a big boost to the stock market. But, in fact, February 15 was the relative high of the S&P 500 - as OIL was gapping higher, the stock index began to decline.

It is clear that the price of crude oil had nothing to do with the bull market of 2010/2011, but why was the value of the dollar so crucial? The dollar is a great indicator for conditions that are otherwise hard to quantify, such as the availability of money and global economic stability. The biggest fear of the 2008 crisis was that deflation (shortage of money) will freeze the exchange of goods and services, and thus stop dead the entire economy. As the Federal Reserve oversupplied the US economy with currency (QE2), the deflation concerns all but disappeared.

At the same time, by the fall of 2010, it was clear that the European Bank and the IMF will do what it takes to prop up Greece, Portugal and Ireland. It looked like the EU and its currency - the Euro - would survive after all. Huge financial pools started leaving the safety of the US Dollar and the US Government Bonds, which were yielding close to zero, and moved into assets which promised better returns such as commodities, equities, and foreign currencies. In conclusion, the depreciation of the dollar was evidence that global capital believed that the storm had passed and was leaving the greenback in search of higher risk/return.

I ran a correlation study for the US Dollar Index vs. the S&P 500. Because the depreciation of the dollar causes the appreciation of the stock market, the SPY should move in the opposite direction of UUP (an ETF for the US Dollar Index). To avoid making things too complicated, I used the negative dollar index ETF UDN instead. By default, UDN is the exact opposite of UUP (it is called the bearish dollar), so it should move in the same direction as the stock market. The correlation of SPY and UDN for the past 6 months is 0.4, which means that although it is not perfect, the correlation definitely exists.

The chart below is a more visual proof that the S&P 500 futures are very positively affected by Dollar Depreciation (UDN). For the most part, the two move in sync, often making relative highs and lows concurrently.

Comparison S&P 500 (<a href='http://seekingalpha.com/symbol/spy' title='SPDR S&P 500 Trust ETF'>SPY</a>) and Bearish Dollar Index (<a href='http://seekingalpha.com/symbol/udn' title='PowerShares DB USD Bear ETF'>UDN</a>)

This bull market in equities started with the bailout of Greece, Ireland and Portugal and it looks like it may have ended in May, with the remaining concern about whether Greece will be able to refinance its sovereign debt. The latest bearish data from the Housing and Manufacturing sectors are just as important, but the clincher is that funds are moving back to the safety of the dollar. I would not expect the bull market in stocks to continue until the Greek debt problem is patched up.

Source: What Really Fueled the 2010/2011 Bull Market