How Oil Prices Affect Stock Markets

 

Researchers at the Federal Reserve Bank of Cleveland looked at movements in the price of oil and stock market prices and discovered, to the surprise of many, that there is little correlation between the two. Their study does not necessarily prove the price of oil has a very limited impact on stock market prices; it does suggest, however, that analysts cannot really predict the way stocks react to changing oil prices.

It is popular to correlate changes in major factor prices, such as oil, and the performance of major stock market indexes Conventional wisdom holds that an increase in oil prices will raise input costs for most businesses and force consumers to spend more money on gasoline, thereby reducing the corporate earnings of other businesses. The opposite should be true when oil prices fall.

So why can’t Fed economists find a stronger correlation between stock market and oil prices? There are several likely explanations. The first and most obvious is there are lots of factor prices in the economy, such as wages, interest rates, industrial metals, plastic and computer technology, that can offset changes in energy costs. Another possibility is that corporations have become increasingly sophisticated at reading futures markets and are better able to anticipate shifts in factor prices; a firm should be able to switch production processes to compensate for added fuel costs. Some economists suggest that general stock prices often rise on the expectation of an increase in the quantity of money, which occurs independently of oil prices.

Stock prices rise and fall based on future corporate earnings reports, intrinsic values, investor risk tolerances and a large number of other factors. Even though stock prices are commonly aggregated and lumped together, it is very possible oil prices affect certain sectors much more dramatically than others. In other words, the economy is too complex to expect one commodity to drive all business activity in a predictable way.

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