How Oil Moves Stock Prices

An important question in asset markets is whether oil prices are a global factor in asset returns. In this paper, we propose a hierarchical model of stock returns which assumes that markets are integrated conditional on a set of factors, including oil. The hierarchical model is a variant of the Jorion and Schwarz model of market integration and permits significance testing of factors at three levels; global, country and sector. In an application to three countries across nine common sectors, we found the pattern of significance of oil was different than for six other commodities. While there is no evidence that oil is a global or country factor, there is evidence that oil is more significant at the sector level than other commodities. The average P-values for oil are less than for other commodities and, in Wald tests across sectors, oil behaves like a global market factor and a country market factor. The effect of oil is therefore both disaggregated and heterogeneous. There are two important implications of this study. First, in the aggregate, stock prices appear remarkably insensitive to oil prices, suggesting that the correlation between stock prices and oil prices is less certain than usually perceived. While an oil shock may cause a real economy recession, it does not necessarily cause an asset economy recession. A second implication relates to the testing of linear factor models. If factors affect asset prices in a hierarchy rather than linearly, tests of factor models must adjust for the hierarchical structure.