Oil and stock market momentum

Highlights: • Oil return volatility predicts momentum payoffs in the Chinese stock market. • Oil absorbs the predictive power of stock market volatility and state. • Oil's predictive power is robust to the inclusion of key macroeconomic variables. • Predictability comes from winner industries. • Oil-based momentum strategy generates significant abnormal profits. - Abstract: This study provides a novel perspective to the oil-stock market nexus by examining the predictive ability of oil return and volatility on stock market momentum in China. We find that oil return volatility serves as a strong predictor of industry momentum, even after controlling for stock market state, volatility and key macroeconomic variables. We argue that the predictive ability of oil over momentum payoffs is driven by time-varying investor sentiment that relates to excess buying pressure on winner stocks during uncertain times, captured by oil return volatility. Our tests also show that an oil-based momentum strategy wherein the investor conditions the trade on the state of oil return volatility yields significant abnormal returns, more than double that could be obtained from the conventional momentum strategy. In short, the findings suggest that oil market dynamics can contribute to stock market inefficiencies in such a way that these inefficiencies create significant abnormal profits for active managers.