One of the least expected results of the recent crash in oil has been the seemingly tight correlation between oil and stock prices. Recently, when oil slides, so does the stock market. This hasn’t always been the case. Prior to oil’s recent decline, the correlation between the movement of oil and stock prices had been around 20%. Nowadays, the correlation is around 90%. What gives? Will this persist?
Analysts suspect that this oil-stock correlation is due to position covering. In short, when large trading firms or institutional investors get hit by crashing oil prices, they sell off equities they’re showing a paper profit in. Analysts suspect that this shifting of positions lead to a neutral or positive bottom line for funds and institutional investors.
Another school of thought focuses on what the price of oil means to market players. According to this line of analysis, traders tend to sell of stocks when they feel softens in oil prices because oil is an indicator of global demand. Global demand, by extension, is a reflection of fundamental economic strength or weakness at the macro-level. In short, they see softening oil prices as an indirect indicator that market fundamentals don’t warrant betting long. Regardless, it appears from oil and stocks’ recent performance that the close dance between the two might be coming to an end as the market’s attention focuses on the European Central Bank’s widely anticipated $1.1 trillion quantitative easing initiative. With this fresh injection of liquidity in the market, the stock market may look for other economic signals to track.