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A Study in… The Stock Market

Diversification of investing – putting money in a variety of types of funds – is an important part of many investment strategies. Investing in international funds is one aspect of diversification. How much benefit there is to putting money into international funds depends on many factors, one of which is how closely the returns of the U.S. stock market correlates with international markets.

This research article may help people who invest in foreign markets better understand the correlation between the United States stock market and foreign stock markets and help them to determine whether or not to invest in foreign markets.

Purpose

The stock market crashes of 1987 and 2008 were the most important crashes on a global scale since the 1929 crash that led to the Great Depression. Research studies after the stock market crash of 1987 showed increased correlation between national stock markets, which meant that the benefits of global diversification became limited.

The authors of this study set out to examine the co-movements of the United States stock market and European stock markets before and after the 2008 crash. The purpose of the study was to determine if diversification in foreign markets was a good investment choice following the 2008 crash.

Data Collection

Sample. The sample for the study consisted of the U.S. stock market and the stock markets of 20 European countries. Some of the countries included in the study were Austria, France, Ireland, Spain, and the United Kingdom.

Data Collection. The data for this study were taken from the DataStream database of the Morgan Stanley Capital International weekly U.S.-dollar stock market indexes. Data for the five years 2003 through 2007 were collected for the pre-2008 crash period. Data for the five years 2009-2013 were collected for the post-2008 crash period.

Data Analysis and Results

The researchers first calculated the Pearson correlation coefficients between the U.S. stock market’s returns and each of the 20 European stock markets.

This analysis showed that the correlation of returns was greater after the 2008 stock market crash than before the crash.

On average, the correlation between the U.S. stock market and European stock markets was 0.522 before the crash and 0.737 after the crash, which represents a 41% increase in correlation. The smallest change (an 8% increase) was between the U.S. market and the market of the Netherlands, which was already high (0.743 to 0.804). The largest change (183%) was between the U.S. and Hungary (0.236 to 0.668).

The higher the correlation between the U.S. and a European country’s market, the less portfolio diversification is gained by U.S. investors buying stocks in that country’s market.

Similar analyses were carried out between all of the countries’ stock markets. Overall, the correlation coefficient increased from 0.587 before the 2008 crash to 0.740 after. This indicated there was less opportunity for diversification in other countries’ stock markets after the crash than before for both American and European investors. This part of the analysis did show that among all the countries, the lowest correlations (and, thus, best opportunities for diversification) came between the U.S. and three other countries: Hungary (0.236), the Czech Republic (0.255), and Turkey (0.264).

The researchers conducted an analysis of the covariance of the coefficient correlations. From this analysis, the researchers concluded that the changes in correlations among the 21 stock markets in the study were statistically significant for the pre-2008 and post-2008 periods.

They also used Principal Components Analysis (PCA) on the co-movement patterns of the sample markets for before and after the 2008 crash. In PCA, the stock markets are grouped “in terms of the similarities of their movement patterns.The stock markets that are highly correlated would have high factor loadings in the same principal component. …The stock markets with high factor loadings in different principal components have low correlation” (p. 94).

For the pre-2008 crash, there were two statistically-significant components, which explained a total of 71.5% of the variation in the data and meant there were some stock markets (in particular, those of Denmark and Portugal) that offered some diversification options. However, for the post-2008 crash, the results indicate that there was only one statistically-significant component, which accounted for over 75% of the total variation, meaning – once again – that all the stock markets were highly correlated.

Summary and Significance

Using correlation and Principal Components Analysis, the authors of this study found that there was significant change in correlation of the movements of the stock markets of the United States and the 20 European countries included in the study between the pre- and post-2008 stock market crash periods. The significance of this study comes in providing guidance for investors on diversifying their portfolios. Because of the high correlations, the authors conclude that there was a significant decrease in diversification opportunities from before the 2008 stock market crash to after the crash.

Reference:

Meric, I., Nygren, L. M., Bentley, J. T., & McCall, C. W. (2015.) Co-movements of U.S. and European stock markets before and after the 2008 global stock market crash. Studies in Business and Economics, 10(2), 83-98.