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Why the S&P’s Correlation with Oil has Changed

Traders today are wondering why crude oil and the stock market are suddenly so connected, and it’s a great question. Studies from 2008 have shown that there is absolutely no correlation between the price of oil and the S&P 500. Other studies that have dated back 20 years have shown that the correlation can go as high as 25 percent at times. However, over the course of the last two months, that correlation has been 90 percent. Something has changed in the world economy that has impacted this, and it only makes sense that we should try to figure out what that is. Knowing the answer to this question can not only give us a good idea of what we can expect in the future, but also how we can profit from the ongoing changes in market conditions.
Price Action on OilThe big issue that seems to be influencing prices is that there is a huge risk of default in oil and energy companies. In order for companies to show any sort of profitability, a large amount of startup capital is needed, and this is done in the form of debt in most cases. So, now that oil’s price has dropped by about 80 percent, there is a much larger chance of default in these cases, and the likelihood of bankruptcy is very high. There are over 550 oil companies in the world, and more than 99 percent of them are currently in prolonged bear markets. More than 30 percent of those companies are down 90 percent or more off of their highest prices. In other words, the market has completely turned on these companies, and thanks to the fact that they are so dependent upon a currently failing commodity, the longer prices stay down, the more likely these companies are to go under. And when they go bankrupt, there will be a ton of unsettled debt.

And if you consider the fact that the world is still wary because of the 2008 financial crisis, this makes a lot of sense. Of course, the sector that was affected in 2008 was different, but the setup for this current scenario is almost exactly the same. Major financial companies are already taking precautions to protect themselves from this issue. Wells Fargo has reported losses of $90 million for a single quarter just in its oil and gas portfolio. To prevent something similar, Citigroup has recently added an extra $250 million to its reserves that is earmarked for bad energy loans. The financial industry is not being caught unaware, in most cases by this, but the fact that prolonged slumps in the price of oil can impact an entire economy is starting to come to fruition.

As we craft our own trades, this fundamental information is a necessary part of the framework that we need to take into account. Binary options traders have a degree of freedom as they have no limits on the direction of the trades that they can make when it comes to cost. Other market traders should be looking for low cost alternatives to take advantage of falling prices. Selling stocks short is a good choice for traders with a large amount of expendable capital, but many of the companies that are struggling the most are no longer able to be sold short because of government restrictions. This leaves commodity futures as an alternative, but this requires an even greater amount of capital as the frequent trading of futures is extremely cost intensive when it comes to fees. The Forex market is a cheaper alternative, as are currency binary options, but this requires an in depth understanding of international marketplaces and how economies impact currencies. For a studious trader though, these places are the most approachable from a cost standpoint.