Abstract:
This paper investigates the role of permanent and transitory shocks, within the framework of
common cycles and common trends, in explaining stock and oil prices. We perform a
multivariate variance decomposition analysis of monthly data on the West Texas
Intermediate (WTI) oil price and the S&P500. The dataset used in the study spans a long
period of 150 years and therefore contains a rich history to examine both the short- and longrun
comovement properties of oil and stock prices. Given that the oil and stock markets might
comove both in the short- and long-run, it is of interest to see the relative impacts of
transitory and permanent shocks on both variables. We find that (log) oil price and (log) S&P
500 share a common stochastic trend for our full sample of September 1859 to July 2015, but
a common cycle only exists during the post-WW II period. Full and post-WW II samples
have quite different common feature estimates in terms of the impact of permanent and
transitory shocks as measured by the impulse responses and forecast error variance
decompositions. We also find that in the short-run oil is driven mostly by cycles (transitory
shocks) and stock market is mostly driven by permanent shocks. But, permanent shocks
dominate in the long-run.
