The dramatic drop in the price of oil took has taken a toll on the equity markets. Throughout the recent year, the S&P 500 Energy Sector Index declined by ~30% while the price of crude oil declined from ~$50 to ~$30, with the possibility of falling even further.
Though it makes up only 6.5% of the overall S&P 500 Index, the energy sector had a significant impact on overall market sentiment. The idea that lower energy prices might only have a local effect on this sector, while all other sectors would prosper, did not prevail. Falling energy prices and the drivers for that -- whether the low demand from China, the global economic slowdown, or the oversupply that has happened with Saudi Arabia -- had a colossal impact on the equity markets, which was far beyond any specific sector. The industrial sector and the financial sector are two of the sectors that faced a significant pullback together with the energy sector.
In recent months, especially in the first trading month of 2016, it felt as if the Equity Index was following the behavior of oil prices. As the oil prices fell below the $30 level, the S&P 500 faced a significant sell-off and set a new 52-week low at 1,812 points.
In order to validate that there is indeed a strong correlation between the price of oil and the equity market, below is a graph that summarizes the recent year's correlation (by month) between the oil price -- represented by The United States Oil ETF (NYSEARCA:USO) -- and the S&P 500 Index, represented by The SPDR S&P 500 Trust ETF (NYSEARCA:SPY).
Source: Created by author.
In nine out of the examined 13 months, the price of oil faced a monthly reduction. The graph proves the point that during the recent three months, the two indexes behaved in a highly correlated fashion with correlation levels that only grew over time.
Another interesting observation is that the length of the "high correlation period" is growing throughout time. The month of April 2015 delivered the first high correlation of >0.5 points, and therefore would be the first month to start counting from. From April through July, the positive correlation was seen every other month (in April and June). Between the months of July and October, the high correlation took place for a two-month period (throughout the months of August and September). The recent period of three consecutive months of positive correlation is no doubt the longest one.
The question is whether or not the month of February will behave similarly to May, July and October, and deliver a negative correlation between these two indexes. The first indication has been seen in the last couple of trading days. The graph below shows the behavior of SPY and USO since the beginning of 2016. The recent week indicates that the equity market is trending upward while the oil price continues to swing, with a risk of falling back to recent lows at $28-$29.
The risk is that any additional reduction in the price of oil could lead to significant turbulence, as there are many economies around the world that are dependent on black gold. A lower price point could lead to a ripple effect that would have an impact on the U.S. economy. This type of new paradigm would impact not only the trends on Wall Street but also on Main Street, due to the risk for the employment rate and inflation expectations.
As long as the price of oil doesn't set a new low in the low $20s or high teens, it seems as if the equity indexes have a good chance of trying to recover from the recent pullback. And that, at least temporarily, would degrade its correlation with the behavior of the price of oil. The equity markets are now focused on the current earnings season and expectations for 2016. The month of February is expected to be very interesting.
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