Ten years ago, when Black Monday roiled the U.S. market, pension funds couldn't find a hiding place in international markets. The spillover effects were almost instantaneous, leaving most foreign markets devastated.
Today, investors still could expect the same worldwide fallout from the sudden crash of a major market.
According to Khalid Ghayur, head of global research for HSBC Asset Management in London, world market performances are strongly correlated in periods of decline.
The flip side of the equation, however, is that markets remain only weakly correlated on the upside. And because periods of market appreciation last longer than declines, markets on average still aren't strongly correlated, Mr. Ghayur's data show.
According to his statistics, between January 1982 and August 1996, the correlation between the U.S. market and the Morgan Stanley Capital International Europe Australasia Far East index in U.S. dollar returns was 38.9% when both were rising, but a much larger 56.8% when both were in decline.
The average correlation between them was 43.6%.
Certainly, such statistics are good news for pension funds, which continue to expand their horizons internationally. According to InterSec Research Corp., as of year-end 1996, U.S. tax-exempt institutions had invested some $475 billion overseas - or 10.9% of their total assets - compared with $50 billion or 2.6% of assets at the end of 1987.
"Over the last decade, when markets have been taken down together, they bounce back together. But when things settle down, they go their own way," observes Jim Waterman, senior vice president of InterSec, Stamford, Conn.
"Most markets continue to be driven by local investors, even though their percent of foreign investment has increased. So to that extent, we expect continued diversification benefits, even as global investing continues to grow on a worldwide basis," he said.
Closer scrutiny shows that markets are more uncorrelated over longer time periods than shorter ones. (When markets are moving completely in lock-step, the correlation would be 1; when their movements bear no relationship, the correlation is zero.)
According to Frank Russell Co. Tacoma, Wash., the 10-year market correlation between the Standard & Poor's 500 Stock Index and the MSCI EAFE index was a mere 0.36 in 1986. Ten years later, that comparable figure was 0.48.
However, the three-year rolling correlation for the period through August of this year was nearly 0.6; and for the five-year rolling period through August, it was just over 0.5.
Nonetheless, Gunter Ecklebe, Frank Russell's director, institutional markets, cautions against drawing any conclusions about shorter-term correlations. He pointed out the-three year rolling correlation for the period ended August was lower than even for the period around 1982, when it was roughly 0.65.
Still, individual markets have become more correlated with the United States, Frank Russell's data show. Charting the correlations of six countries' markets with that of the United States between 1983 and 1996, Russell found:
The correlation between Germany's market and the U.S. market rose to 0.41 at the end of 1996, compared with 0.29 at year end 1983. For the same periods, the correlation with the Netherlands' market rose to 0.67 from 0.57; that with the U.K. climbed to 0.66 from 0.46; in Hong Kong it increased to 0.56 from 0.32; in Japan, to 0.27 from 0.23; and in Singapore, to 0.63 from 0.49.
To Mr. Ecklebe, these findings support the practice of "strong diversification among international markets" - rather than concentrating investments in individual markets.
But even if markets aren't strongly correlated overall, they do follow a leader downhill, as HSBC's data show. Thus, some investors might wonder, as the 10-year anniversary of Black Monday approaches, about current world market conditions. Could a worldwide crash again be in the offing?
The answer seems to be no.
Although plunges in Southeast Asian markets recently rippled around the world, they didn't trigger a crash of a major market outside of that region.
And even concern about valuations in the United States and Europe are being viewed with an up-to-date perspective. If corporate earnings in these areas remain handsome, or even improve, market valuations still will appear acceptable, albeit high, many say. But if earnings expectations dwindle, or if interest rates climb, investors could become scared.
"Conditions are very different than they were in 1987," said Ivan E. Stux, principal with Morgan Stanley Dean Witter in New York. "But there is danger in the market now," he said, citing the earnings issue. "Now, there is a feeling in the market that (U.S. corporate) earnings will deteriorate. If the earnings slowdown is mild, people will live through it. But if it's severe, people could get scared," he said.
And, because the United States is a "leading economic engine of the world," any sizable slowdown here would "reverberate" in other markets, he added.
Matthew Merritt, global strategist with London-based ING Barings, sees the "downside risk of a 5%-10% decline in the U.S. market between now and year's end." A rise in bond yields, if it occurs, would be major culprit.
"And next year, assuming the (U.S.) economy moderates and bond yields decline, earnings will cap U.S. stock market" gains, he said. Nonetheless, next year, the S&P 500 index should be able to climb modestly to 1,010 in the third quarter, he said.
But if Wall Street declines in the near-term will foreign markets follow? "That depends on which of the scenarios comes through," said Mr. Merritt. "If higher interest rates knock Wall Street off its perch, then global equity markets will come down," predicted Mr. Merritt. "But if it is lack of corporate earnings or earnings fears that derail U.S. equities, then it's more likely that other markets can break away form from the influence of U.S. equities."
Michael Levy, managing director and head of international equities, Bankers Trust Co., New York, believes that major markets outside the United States, especially in Europe, are "looking forward to improving economic conditions and (higher) earnings. So I don't think they are overvalued. And if the U.S. market has a correction, it's not likely to be as severe as in 1987."
In fact, because U.S. corporate earnings are slowing "it would be healthy for the market to have a correction," he said.
