Oil prices and stock market anomalies

Highlights: • Individual stock market anomalies show weak evidence of mispricing in China. • Aggregating anomalies produce stronger evidence of mispricing in China. • Anomalous returns are higher following rising oil prices than falling oil prices. • Higher anomalous returns following rising oil prices are due to higher demand for oil. -- Abstract: This paper examines the relationship between oil prices and stock market anomalies in China, the largest oil importer country in the world. Prior literature documents both a positive and negative relationship between oil prices and the stock market. The explanation of a positive relationship is supported by the argument that rising oil prices are interpreted as a positive signal by investors, especially when the rise in oil prices is associated with a higher demand for oil. Consequently, rising oil prices lead stock prices above their fundamental values and that they subsequently correct. Therefore, we hypothesize that stock market anomalies are stronger following rising oil prices when the rise in oil prices is due to the higher demand for oil since returns associated with anomalies reflect mispricing. The results, consistent with the hypothesis, show stronger return predictability for individual anomalies following an increase in oil prices than for a decrease in oil prices. The results are even stronger once we construct a mispricing score based on composite mispricing of all the anomalies.