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Changes in oil prices predict stock market returns worldwide. We find significant predictability in both developed and emerging markets. These results cannot be explained by time-varying risk premia as oil price changes also significantly predict negative excess returns. Investors seem to underreact to information in the price of oil. A rise in oil prices drastically lowers future stock returns. Consistent with the hypothesis of a delayed reaction by investors, the relation between monthly stock returns and lagged monthly oil price changes strengthens once we introduce lags of several trading days between monthly stock returns and lagged monthly oil price changes.

The main contribution of our paper is that we are the first to document evidence showing that changes in oil prices forecast stock returns. This predictability is especially strong in the developed markets in our sample of countries and in the world market index. It seems unlikely that this predictability can be attributed to time-varying risk premia because the predictability is short-lived and oil price changes tend to be uncorrelated with other economic variables generally associated with predicting time-varying risk premia, and perhaps more importantly, because higher oil prices predict lower stock returns. This finding is difficult to align with oil price changes as an indication for future risk premia, because oil shocks would lead to higher economic risk and therefore higher returns, not lower. Oil price changes meet the extreme standard put forward by Schwert (2003), which states that forecasts should also include forecasts in the negative excess return domain. Moreover, the relation between stock market returns and lagged oil price changes is statistically significant in many countries even if we restrict our analysis to the predicted negative excess return domain. Based on these results we conclude that oil price changes are exceptional. The predictability of all economic variables known to date might be a consequence of time-varying risk premia; however, this conclusion does not hold for the predictability of stock market returns based on oil price changes. These results point in the direction of a true market inefficiency. A possible explanation for our findings is that investors react at different points in time to changes in oil prices, or have difficulty in assessing the impact of these changes on the value of stocks not related to the oil sector. As we show, our results are consistent with the gradual information diffusion hypothesis proposed by Hong and Stein (1999). First, the delayed reaction is negative in most countries. Second, if we allow for lags between monthly stock index returns and lagged monthly oil price returns, we find stronger results. The explanatory power of these regressions increases up to a lag of 6 trading days and then rapidly decreases. As we show, this finding is in line with a delayed reaction of investors. These results suggest that investors underestimate the direct economic effect of oil price changes on the economy and act with a delay. Our finding that underreaction to oil price changes is less pronounced in oil-related sectors offers further support to this hypothesis.