Why Are Global Markets So Interconnected?

Guild Investment Management |

It’s because of the history of how markets and their participants have evolved. I entered the business as an analyst in 1968, after having been a part-time private investor from the late 1950s during my teenage years. My experience is that through the 1980s, stocks moved individually due to fundamental improvements or deterioration of their businesses. 

If General Electric (GE) profits rose, the stock went up. If their profits fell, the stock went down. 

Beginning in the 1990s, things changed. More volatility and much more correlation and interconnectedness between markets resulted. 

Interconnected.jpg

What happened? 

1. Hedge funds, with their large degree of leverage (commonly 10 times leverage or more), became more prevalent. 

2. Exchange-traded funds (ETFs), which aggregate stocks into a group according to market, sector, industry, or some other classification (for example, all stocks in the S&P 500, all the stocks in Europe, all the drug stocks, all the telecom stocks, etc.) became more common. As ETFs have gained traction and absorbed a greater and greater amount of investors’ capital, they have become more and more influential. When investors buy the ETF, all the component stocks go up; when they sell it, all the stocks began go down -- irrespective of their fundamental merits. All the stocks in an index or other group began to move together, becoming much more highly correlated than they had been in the past. In addition, ETFs now exist that employ leverage to provide returns double or triple that of their underlying index. 

3. Large money-management firms arose which manage hundreds of billions or trillions of Dollars. Such huge funds, moving massive amounts of capital in concert into and out of given markets, sectors, and industries, strengthen correlations still further -- especially since their managers are often reacting to the same macro events and using similar analytical techniques. 

4. Thanks to the rise of the internet, information and misinformation spreads ever more rapidly through global financial markets. This volatile flood of information creates more violent swings of fear/greed sentiment than were seen in the past. 

5. With each passing year, interconnectedness grows stronger as these trends grow in significance in the global investment mosaic. 

Do individual companies and their fundamentals still matter? 

The answer is a resounding “yes.” 

The differentiation between companies becomes more apparent particularly during market downturns -- when companies with strong fundamentals get pulled down indiscriminately with their weaker peers. After a correction has run its course, these bargains can outperform, even in an environment where there are trends driving higher correlations.

Indeed, there has been one additional powerful force driving correlations that we have not yet mentioned: the extremely accommodative monetary policies pursued by the world’s central banks in response to the global financial crisis and its aftermath. Those policies have created a flood of money looking for a return, and has multiplied the effects of the correlation trends we noted above. Those policies aren’t exhausted yet, but with U.S. QE over, and rate hikes appearing on the horizon, a world is coming into view in which correlations driven by central bank liquidity will diminish. In our view, this bodes well for investors who buck the trend, and do the work to identify strong, undervalued companies whose stocks have been brought to an attractive price level by irrational market action. 

Today and in the near future, we believe the opportunity will arise to buy quality companies that are undervalued and that are unreasonably declining due to fear about the entire group of which they are a part. 

Investment implications: Since the 1990s, several trends have increased the interconnectedness of global markets and the correlation of many assets: the rise of hedge funds; the growth of ETFs, the influence of huge money-management firms, and the rapid spread of information and misinformation through the internet. The easy liquidity provided by the world’s central banks after the global financial crisis only exacerbated these tendencies. However, the current correction illustrates the potential of careful analysis of individual stocks which have been brought down irrationally by market forces. As extraordinary monetary policies are gradually normalized, corrections like this one will offer intelligent investors even more opportunities to profit by bucking the trend.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
GE General Electric Co 31.34 -0.05 -0.16 21,401,028

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