Oil price shocks and the US stock market: A nonlinear approach

Abstract

We study the response of US stock market returns to oil price shocks and to what extent it behaves asymmetrically over the different phases of the business cycle. For this purpose, we decompose the oil price changes into supply and demand shocks in the oil market and assess the state-dependent dynamics of structural shocks on US stock returns using a smooth transition vector autoregression model. When nonlinearity is considered, quantitatively very different asymmetric dynamics are observed. Our findings show that the responses of US stock returns to disaggregated shocks are asymmetric over the business cycle and that the impact of demand-driven shocks on US stock returns is stronger and more persistent, especially when economic activity is depressed. Furthermore, the contribution of shocks to expectation-driven precautionary demand in recessions accounts for a larger share of the variability of US stock market returns than that predicted by standard linear vector autoregressions. • State-dependent effect of oil price shocks on US stock returns is investigated. • We decompose oil price changes into supply and demand shocks. • A smooth transition VAR is used for asymmetric dynamics over the business cycle. • Demand-driven shocks are larger and more persistent during recessions. • Oil price shocks explain around 40% for US stock market variations in recessions.