Need a New Barometer for Stocks? Try the Price of Oil
By MARK HULBERT
Published: November 2, 2003
OVER the last 30 years, stock investors could have beaten a buy-and-hold strategy by following a simple market-timing model based on the price of oil.
That is the conclusion of a new study by Ben Jacobsen, an associate professor of finance at Erasmus University in Rotterdam, the Netherlands, and two of his students, Gerben Driesprong and Benjamin Maat.
While many researchers have found that the price of oil affects the American economy, Professor Jacobsen could find no previous studies that measured the extent to which changes in oil prices could predict the stock market's performance. He and his colleagues studied the relationship between oil prices and the American stock market from October 1973 to April 2003. (They chose their starting date because the price of oil generally changed infrequently before 1973, and by small amounts.) The researchers found that "changes in oil prices strongly predict future stock market returns."
The study recently began circulating in academic circles as a working paper. It is available at http://papers.ssrn.com/sol3
To illustrate the implications for investors, the researchers constructed a hypothetical portfolio invested entirely in the domestic stock market, as measured by the U.S.A. Total Return index from Morgan Stanley Capital International, whenever the price of oil declined during the previous month. The portfolio shifted entirely into short-term Treasury bills whenever oil prices rose during the previous month by more than 5 percent. When the oil-price increase was less than 5 percent, the researchers kept the portfolio in stocks, theorizing that the negative impact of more expensive oil was probably not enough to counteract the long-term historical tendency of the stock market to rise.
During the period studied, this market-timing portfolio, after transaction costs, gained 11.5 percent, annualized. By contrast, a buy-and-hold strategy in the stock market throughout that period gained 10.4 percent a year, on average. Better yet, the market-timing portfolio was 30 percent less risky than buying and holding, as measured by the volatility of its returns.
Although he said the results were statistically significant, Professor Jacobsen acknowledged that he would be more confident if he could replicate them over other periods. That is not possible now, because oil did not trade freely before 1973.
Nevertheless, he and his students conducted several other tests that increased their confidence that the market-timing model was worth betting on.
In one test, they examined the impact of oil prices on the stock markets of 17 other industrialized countries over the same period. In addition, they studied the markets of 30 emerging-markets nations over shorter periods for which data were available. They found that changes in oil prices had considerable predictive power in those markets, too. In a number of countries, in fact, the researchers' oil-based market-timing model was even more profitable than it was in the United States.
In another test, the researchers divided the 30-year period into two parts - 1973-1988 and 1988-2003 - and analyzed them separately. Their market-timing model was profitable in both periods.
ALTHOUGH the researchers' results were statistically significant, they found that the stock market moved in the direction suggested by the model only 52 percent of the time. The strategy was so profitable, however, because the portfolio generally lost only small amounts when the model's predictions were wrong; the portfolio tended to perform very well indeed when the predictions were correct.
In October, the stock market behaved as the researchers' model predicted. The price of crude oil fell 6.2 percent in September, suggesting that October would be a strong month for the market. The U.S.A. Total Return index rose more than 5 percent for the month.
Mark Hulbert is editor of The Hulbert Financial Digest, a service of CBS MarketWatch. His column on investment strategies appears every other week. E-mail: