Oil is more complicated than you think

The massive drop in oil prices isn't even the biggest one in the last decade. The 2008 recession saw oil hit a similarly low level, but it started falling from a much higher peak, and on an even faster time scale. On a percentage basis, the price of Brent crude oil also saw many large drops between 1997 and 2002.

That suggests two things: (1) the markets have weathered storms like this before, and (2) prices could still drop before recovering. Here's a chart comparing oil and the S&P 500 over the past 20 years. (Funny enough, from a starting point in December 1995, both have gone up about the same.)

Another factor to remember: It's not just oil prices that have fallen. A broad range of energy and industrial commodities have all seen sharp drops. Notice steel, iron ore and propane have each dropped more than oil in the past five years. You can see in the chart how a variety of commodities have all fallen in the past 12 months.

And finally, some people will make the point that oil and the stock market don't have any correlation. That might technically be true if you compare their price movements over a long period of time. But here's the thing that traders know: oil and the stock market have a hot and cold relationship. Sometimes oil is correlated with equities, and other times it's not.

This is the key area where you can make money trading these macro relationships.

Good traders can tell when these "regime changes" will happen, when oil becomes a proxy for stocks versus a hedge for stocks. That's why the correlations need to be looked at in short-term intervals. You can see below how the correlation between oil and stocks has changed over time. It's a very volatile chart, and suggests how traders can get burned trying to figure out which way the two will relate to each other.

Look in the early 1990s for an extreme contrast — oil and stocks were negatively correlated (by a lot), meaning they were hedges for each other. But right now we are at the highest correlation levels we've seen in the entire chart. The rolling one-year correlation between oil and stocks hasn't been this high since at least the 1980s.

A lot of that high correlation comes from the dynamics of this summer, when equities and energy both tanked at the same time, and then rebounded together.

At some point that relationship will start to disappear, and switch back to negative. The question is, will that be because oil is rising and stocks are falling, or because oil continues to drop while stocks rebound to new highs?

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