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Striking Oil: Another Puzzle?

Last Updated on 10 February, 2024 by Rejaul Karim

In the enigmatic dance between oil prices and global stock markets, “Striking Oil: Another Puzzle?” unfolds a mesmerizing narrative penned by Gerben Driesprong, Ben Jacobsen, and Benjamin Maat.

Published in the Journal of Financial Economics, this forthcoming exploration challenges conventional wisdom, revealing a striking predictability: changes in oil prices serve as an uncanny harbinger of stock market returns across developed and emerging markets. A captivating thirty-year odyssey through monthly returns showcases a statistical symphony, with twelve out of eighteen countries, alongside the world market index, succumbing to the mystique of oil’s forecasting prowess.

Intriguingly, the paper dismisses the notion of time-varying risk premia, portraying investors as unwitting voyagers navigating the turbulent seas of oil price shifts. The revelation? A paradoxical underreaction, where a surge in oil prices doesn’t herald higher stock returns but, rather, a stark descent. The findings hint at a delayed waltz between investors and oil price changes, unveiling a nuanced market inefficiency that challenges conventional market efficiency.

Abstract Of Paper

Changes in oil prices predict stock market returns worldwide. In our thirty year sample of monthly returns for developed stock markets, we find statistically significant predictability for twelve out of eighteen countries as well as for the world market index. Results are similar for our shorter time series of emerging markets. We find no evidence that our results can be explained by time varying risk premia. Even though oil price shocks increase risk, investors seem to underreact to information in the price of oil: a rise in oil prices does not lead to higher stock market returns, but drastically lowers returns. For instance, an oil price shock of one standard deviation (around 10 percent) predictably lowers world market returns by one percent. Oil price changes also significantly predict negative excess returns. Our findings are consistent with the hypothesis of a delayed reaction by investors to oil price changes. In line with this hypothesis the relation between monthly stock returns and lagged monthly oil price changes becomes substantially stronger once we introduce lags of several trading days between monthly stock returns and lagged monthly oil price changes.

Original paper – Download PDF

Here you can download the PDF and original paper of Striking Oil: Another Puzzle.

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Author

Gerben Driesprong
Erasmus University Rotterdam – Rotterdam School of Management

Ben Jacobsen
Tilburg University – TIAS School for Business and Society; Massey University

Benjamin Maat
APG Asset Management

Conclusion

In conclusion, this study unveils a captivating puzzle in the relationship between oil prices and stock market returns across global financial landscapes. Over a three-decade span, the research exposes statistically significant predictability in the stock returns of twelve out of eighteen developed countries and the world market index, a pattern consistent in emerging markets as well.

Importantly, this predictive power persists even when accounting for variations in risk premia, suggesting that the observed phenomena cannot be solely attributed to changes in market risk. The underreaction hypothesis comes to the forefront, indicating that investors may not promptly adjust their expectations to oil price changes. Strikingly, a rise in oil prices does not translate into higher stock market returns; instead, it appears to exert a significant negative impact.

The findings align with the notion of a delayed response by investors, with the relation between stock returns and lagged oil price changes gaining prominence over multiple trading days. This research underscores the intricate dynamics between oil prices and global stock markets, challenging conventional notions of market efficiency and providing a nuanced perspective on return predictability.

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FAQ

Q1: What is the main finding of the paper “Striking Oil: Another Puzzle?” regarding the relationship between oil prices and stock market returns?

The paper reveals that changes in oil prices predict stock market returns globally. The study, spanning thirty years of monthly returns for developed and emerging markets, demonstrates statistically significant predictability in the stock returns of twelve out of eighteen developed countries, as well as the world market index. This challenges conventional wisdom and suggests a noteworthy relationship between oil prices and stock market movements.

Q2: How does the paper address the potential influence of time-varying risk premia on the observed predictability of oil prices for stock returns?

The study finds no evidence that the results can be explained by time-varying risk premia. Despite oil price shocks increasing risk, investors appear to underreact to information in the price of oil. The paper suggests that the observed predictability is not solely attributable to changes in market risk, emphasizing a nuanced underreaction hypothesis.

Q3: What is the paradoxical underreaction revealed in the paper, and how does it challenge conventional market efficiency?

The paradoxical underreaction observed in the paper is that a rise in oil prices does not lead to higher stock market returns; instead, it drastically lowers returns. This challenges conventional market efficiency by suggesting that investors may not promptly adjust their expectations to oil price changes. The findings indicate a delayed response by investors, contributing to a nuanced understanding of the complex relationship between oil prices and global stock markets.

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