The Tenuous Connection between Crude Oil and Equities
From 2014 through to the present day we have seen a close correlation between Brent crude oil and the S&P 500 index (SPX). In fact, for the first half of 2014 the correlation ranged between 0 and 1, indicating a positive correlation that increased during that time period. And in the latter half of 2014 we had a negative correlation ranging between 0 and -0.8 indicating an equal but opposite movement in the prices between the two. The positive correlation has increased since the beginning of 2015 and rapidly spiked above 0.5 for the first half of the year. It then plunged midway through 2015 as equities were loosely associated with the up/down movement in the price of Brent crude oil. The strong correlation began in the latter half of 2015, notably Q3 and Q4. It was then that a rapid spike over 0.5 took place and it has been hovering around 0.96 up until recently.
What this means in everyday speak is that the higher the correlation moves towards 1.0, on a positive or negative spectrum, the more closely aligned price movements are between both tradable assets. In the instance of a -1.0 correlation, the movement in the S&P 500 index would be completely opposite to the direction of movement in the price of Brent crude oil. In the case of +1.0, a decrease in the price of Brent crude oil would be mirrored by a decrease in the level of the S&P 500 index. This is precisely what we have been seeing since November 2015 all the way up into mid-February 2016. It is only recently that we have seen a slight disconnect between the price of crude oil and the performance of the S&P 500 index.
Evidence of the disconnect between crude oil prices and the SPX
The proof of the pudding is in the technical analysis. Global economic headlines have been running with the story that plunging crude oil prices are sending equities markets into the red. Every time there is been a temporary spike in the price of crude oil, this invariably translates into greater confidence on equities markets like the SPX. However, this is all being driven by fear and markets that operate in this manner are typically plagued by high levels of anxiety, volatility and uncertainty. And this is precisely what we are seeing because the volatility index (VIX) has been climbing throughout December, January and February. Nonetheless, traders' nerves have been calmed in recent days owing to the divergent movements in the level of the SPX and the concomitant price of crude oil.
Earlier in the week, an announcement was made to the effect that Saudi Arabia and Russia would be holding an emergency meeting in Doha. Other countries were also participating in the informal arrangement, but Iran was noticeably absent. The content of the meeting was significant in that it was the first such meeting between OPEC and non-OPEC members in an attempt to reduce the output of crude oil in order to increase the price. Nothing was agreed upon other than a preliminary understanding that if WTI producers came on board with the idea, it may be possible to reduce overall oil production so that prices could naturally rise. Interestingly enough, the price of crude oil did not spike and maintain a higher level after the talks, and the movement in the SPX was largely unrelated to the discussions in Doha.
Brent crude oil prices and SPX less closely aligned
Instead, what we are seeing is increasing confidence in the fundamentals of the US economy by way of increased retail sales for the third month on the trot in January. This boosted sentiment on the SPX, the Dow Jones Industrial Average and the NASDAQ. For many traders, the weaker correlation between the S&P 500 index and oil prices is a welcome change. The ratio has dropped from a high of 0.96 earlier in the month to 0.80. While this is still significant, it marks a sharp decrease in the responsiveness of the S&P 500 index to price changes in Brent crude oil. Now it is likely that the SPX can be judged on its merits alone and not the temperament of speculators who are less concerned about fundamentals and driven more by the herd mentality.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.