Minyan Mailbag: Oil vs Stocks
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
Though I agree with you that oil and stocks are not correlated using simple correlation, that does not mean that they are not related in any statistical sense. That is why more sophistication multi variant methods have been developed to study causal relationships that are not completely linear, like multiple regression, factor analysis, etc. Whereas simple correlation might not show a linear relationship, multiple regression might show, that in fact, oil has a relationship when you combine it with other variables. These could be inflation or psychological variables like fear.
I know what you are saying (not correlated in a one to one linear sense). But I do not feel it is right to say that oil is not related to stocks in a more complex sense. It may not, but I tend to feel it may. An example might be that if oil trades higher quickly to an all time high, fear of inflation might increase and stocks trade down. But if oil stabilizes, and expectations are that it might not rise much futher, it might have much effect on stock prices.
A great point Tom, great point. Other more sophisticated correlations might exist - we could go up to several variables in trying to determine just that. But the folks that say simply that "oil and stocks are inversely correlated" are using just two variables - oil and stocks - to assert the relationship.
I only 'need' to use a simple linear statistical correlation function to prove that statement is false. If strategists and media pundits want to make more specific assertions that, say, stocks are correlated to changes in oil prices, interest rates and spot gold, I would love to parse that thru the old models and prove them right or wrong (and I don't have to tell you that if such a correlation were to exist, there are literally hundreds of stat arb hedge funds who would have ID'd it before they announced it on CNBC).
Anyway thx so much for your thoughtful response; your deeper level of understanding of stats is a real treat.
Editor's note: The following exchange is on the same topic from a different Minyan Tom.
As an OCD Psychology and Statistics Professor, I am powerless but to respond to your SPX and oil correlation comments. In the most prestigious psychological, peer-reviewed (read "gleefully and anonymously attacked") journals, a correlation of .37, positive or negative, would often be considered evidence of a moderately strong relation between the two variables involved -- in this case, the S&P and oil. Correlations of this magnitude may be found in many articles published in such journals. When variables are governed to a significant extent by psychological factors, such as measurements of capital markets, the measurement error present because people are different, emotional, not completely rational, etc. creates a mathematical ceiling, so to speak, on the possible magnitude of the correlation of ANY two variables.
With that said, I am quite excited by your new complexity analysis models. They are brilliant and I can't wait to read your feedback every day.
Thank you for your great contribution to the Ville!
That's a great point; in certain circles such a correlation can be considered significant (I failed to mention that the 5 year and 10 yr correlations are significantly lower - closer to +0.15). But I would respond by pointing out two things about the "Oil and SPX are inversely correlated" crowd:
(1) they are stating an INVERSE correlation: all the correlations going back from n=1 to n-=10 yrs are positive. And (2) they are clearly implying that one can make money speculating in oil (respectively stocks) if you knew what stocks (respectively oil) was going to do. And a trading strategy based on such a 'causal' relationship would be perhaps the fastest way to the poor house short of literally just burning all of your money in an open pit.
Our goal at MV is to bring into full relief these types of finance-ruining assumptions that are so casually thrown-around. So while the academic literature might provide for a significant correlation in that range, depending on it in the world of trading would make you bankrupt.
Let me make very clear however, I remain humbled by smart readers like yourself that make up the MV clan. I should be reading YOU guys...
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