Striking Oil: Another Puzzle?

Abstract

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.