Oil and Equity Return Predictability: The Importance of Dissecting Oil Price Changes

Abstract

Based on data until the mid 2000s, oil price changes were shown to predict international equity index returns with a negative predictive slope. Extending the sample to 2015, we document that this relationship has been reversed over the last ten years and therefore has not been stable over time. We then posit that oil price changes are still useful for forecasting equity returns once complemented with relevant information about oil supply and global economic activity. Using a structural VAR approach, we decompose oil price changes into oil supply shocks, global demand shocks, and oil-specific demand shocks. The hypothesis that oil supply shocks and oil-specific demand shocks (global demand shocks) predict equity returns with a negative (positive) slope is supported by the empirical evidence over the 1986-2015 period. The results are statistically and economically significant and do not appear to be consistent with time-varying risk premia.

Keywords: Equity Return Predictability; Structural VAR Model; Oil Price Change Decomposition; Oil Supply Shock; Global Demand Shock; Oil-Speci

JEL Classification: C53; G10; G12; G14; E44; Q41