This paper presents empirical evidence of herding contagion between oil market and stock markets, during the oil shock and the US financial crisis period of 2008-2009, after controlling fundamentals-driven comovements. We estimate the forecasting errors of time-varying parameters using the Kalman filter for oil market and 23 stock markets of oil importing and oil exporting countries, which are independent of macroeconomic fundamental factors. A sharp increase in conditional volatility of the forecasting errors is observed in oil market and stock markets during the turmoil period. To capture the pure contagion effects between oil market and stock markets, we analyze the dynamic correlation between forecasting errors of oil price returns and stock indices returns. The empirical results show a significant increase in time-varying correlation coefficients during the oil crisis and the US financial crisis period of 2008-09, which indicates a strong evidence of herding contagion between oil market and stock markets.

The crisis in the US financial market is seen today as one of the biggest financial crises in history. It was a starting point of severe turbulences in other markets as in the case of the oil market. During this crisis, investors tended to leave the stock markets by selling their shares in the process of depreciation. Then, the speculation moved towards the oil market, causing a price increase. This speculation generated a bubble in the oil market which burst in July 2008. Consequently, both oil and financial markets underwent a period of high volatility raising the question of contagion and shocks transmission between the two markets during the turmoil period.

Recent empirical works have studied the volatility spillovers or dynamic correlations between shocks in crude oil prices and set index prices, and found evidence of increased correlations between oil market and stock markets during the oil and financial crisis periods identifying the contagion effect (Ågren, 2006; Malik and Hammoudeh, 2007; Bharn and Nikolovann, 2010; Chang et al., 2010; Choi and Hammoudeh, 2010; Cifarelli and Paladino, 2010; Filis, 2010; Sadorsky, 2011; and Ghorbel et al., 2011 and 2012). The literature on financial contagion is rich as it identifies the contagion channels. Baig and Goldfajn (1999) and Forbes and Rigobon (2002) defined contagion as a significant increase in cross-market linkages after an initial shock to one country or a group of countries.

Applied Finance Journal, Shocks, Herding, Contagion, Oil, Stock Markets, US financial market, Energy Administration Information (EAI), Time-Varying Parameter (TVP), BEKK-GARCH model.