The Two-Way Interconnectedness of Markets

Far too many conclusions are being made based on comparing stock indices. While these indices give an indication of how a particular stock market is performing, different indices for different stock markets are not directly comparable. Furthermore, stock indices no longer give a clear indication of how domestic investors see the future profit potential of companies that are primarily dependent on the economic performance of the domestic economy.

First of all, the nature of companies that form each index dictates the degree of volatility experienced by that index. This is particularly clear when comparing the Dow Jones Index of the NYSE and the Bovespa Index of the Sao Paulo Stock Exchange. More than half of the 30 companies that form the Dow Jones have historical betas below 1.0 and none above 2.0. There are none forming the Bovespa index under 1.0 and many have historical betas over 2.0. There are also linkages between markets that need to understood. Companies included in the Bovespa Index and forming about 66% of that index also trade as ADRs on the NYSE. That means that their stock prices and the index itself will feel the impact of US investor sentiment.

Secondly, the veil of aggregating index values also obscure indications of where individual companies actually see their future long term growth coming from. I think if you look at investor-focused material from Dow Jones companies, you will find that many report that their greatest business growth potential comes from emerging markets. In fact, the global nature of these companies likely reduces their overall investment risk rather than increase it.

The end result is that stock indices are far more interlinked than most actually realize and I wonder if we are getting a magnification of the real impact on emerging market economies through the normal volatility of individual stocks and the flight to safety by American and European investors.

Having said that, the conclusion is not that emerging markets will be spared but that economies and equity markets remain interconnected more rather than less. However, the relationship is much more two-way that many assume. That is, in addition to the negative impacts of the downturn in American and European economies spreading to the rest of the world, the positive impacts of rapid economic growth in emerging markets also flow back to the American and European markets.