Crude oil is one of the most important commodities in the current global world. Simple logic says that oil prices should predict the economy’s performance and, therefore, should also have some predictive ability for equity returns.
Academic research confirms it and what’s more – it shows that oil isn‘t the only commodity with prediction ability (prices of some industrial metals could also be used as equity indicators). Higher oil prices predict lower future equity returns and vice versa. Therefore a simple market timing system that is using oil prices as an indicator of time equities can be constructed.
Equity predictability is explained by the underreaction hypothesis. It seems that it takes time before information about oil price changes become fully reflected in stock market prices. Underreaction can occur due to a possible difficulty for investors to assess the impact of information on the value of stocks, or when investors react to information at different points in time.
per annum, strategy’s performance from table VI for US (compared to 10,7% benchmark return)
volatility from table VI for US (compared to 15,1% benchmark volatility)
not stated
Several types of oil can be used (Brent, WTI, Dubai, etc.) without big differences in results. The source paper for this anomaly uses Arab Light crude oil. Monthly oil returns are used in the regression equation as an independent variable, and equity returns are used as a dependent variable. The model is re-estimated every month, and observations of the last month are added. The investor determines whether the expected stock market return in a specific month (based on regression results and conditional on the oil price change in the previous month) is higher or lower than the risk-free rate. The investor is fully invested in the market portfolio if the expected return is higher (bull market); he invests in cash if the expected return is lower (bear market).
Partially - The selected strategy is a class of “Market Timing” strategies that try to rotate out of equities during the time of stress. Therefore the proposed strategy isn’t mainly used as an add-on to the portfolio to hedge equity.
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