I have recently read an excellent post by Ben Bernanke about stocks and oil prices, which can be found here . Basically, Bernanke is trying to explain the positive correlation between stocks and oil prices recently, which normally is not the case. As oil prices hit the $30 a barrel level, stocks have also seen a similar downturn this year. Couple that with the FED’s plans to slowly unwind QE this year, it seems stocks are heading for a bumpy ride.

So, allow me to briefly explain the conventional theory surrounding the relationship between oil and stock prices. Oil is essentially the basic commodity involved in every business in this planet. It is used in every chain of production imaginable, starting with its main role of providing energy for consumption purposes.

Now, as oil prices decrease, cost of production decrease too since transportation and energy becomes cheaper. As cost of production decrease, firms are able to produce more goods at a cheaper cost and probably fetch a higher profit margin. With firms reporting higher profit margins, the demand for stocks will increase as investors look to purchase companies with higher profit earnings. According to this, when oil price decrease, stock prices increases because of decreased cost, higher profit thus higher demand for stocks.

But as Bernanke analyzed during the last 5 years, there is a persistent positive correlation between oil and stock prices, which is rare. This could mean both prices are reacting to a common factor. The model employed by Bernanke follows closely to the one used by Hamilton, and points to global demand as the common factor.

As explained by Bernanke, demand for oil recently have undergone a downward trend with China leading the pack as it tries to restructure its economy. Demand for commodities have waned, evident by its recent slump, and volatility has risen accordingly. Investors gripped with heightened uncertainty about the world economy, and risk aversion, initiated stock sell offs to safer asset classes.

The story here about oil and stock prices point to a larger problem, namely the slowdown of global demand and consequently growth. With so many emerging countries dependent on China’s appetite for commodities, a demand decline has meant that emerging countries are struggling to find an alternative source of growth. A prime example of this is Australia’s coal industry.

I suspect this is no longer a world that of American hegemony, but one dependent on China for growth.

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