"When America sneezes, Europe catches cold."
Legend has it that this saying originated after the Wall Street Crash of 1929; the U.S. crash sent many European economies into even larger depressions than its own.
But if the events of Feb. 27, 2007, told us anything, it's that America isn't the only market capable of spreading an economic cold anymore. The 9% drop in the Chinese market that Tuesday prompted a near-4% drop in the S&P 500; the U.K. FTSE 100 fell 2%, and the Indian BSE slid 4%.
Even smaller global events have had major impacts on the markets. Just three years ago, an uprising in Nigeria sent oil prices over $50 for the first time, roiling the global markets for a few days.
The development toward highly correlated global markets has become a reality in a very short period of time. According to a recent article in The Economist, international markets have revealed a 95% correlation with the S&P 500; in the mid-1990s, this figure once sat as low as 40%!
In other words, the global markets are dancing in step more than ever before, so while adding international stocks to your portfolio can still lead to big returns, the days of getting a "free lunch" from international diversity may be coming to an end.
Why this is a good thing
The Economist cites various phenomena that are contributing to converging global markets. Among them: reduced controls on capital, a larger number of cross-border listings, and multinational mergers.
In just the past few months alone, some of the world's biggest stock exchanges have announced agreements or mergers to integrate trading systems. Back in April, NYSE Group merged with European market Euronext to create what is now NYSE Euronext. The European Union's internal market commissioner, Charlie McCreevy, said that the NYSE/Euronext union marks the beginning of stock market mergers and "at some point we will see moves toward a common pool of liquidity."
Furthermore, many companies are listed in multiple global markets in order to gain access to foreign capital. Just as some foreign companies appear on U.S. exchanges -- like GlaxoSmithKline (NYSE: GSK ) , Novartis (NYSE: NVS ) , and CNOOC (NYSE: CEO ) -- U.S. companies such as IBM (NYSE: IBM ) , Home Depot (NYSE: HD ) , and General Electric (NYSE: GE ) are listed on the Frankfurt and London exchanges.
Finally, a few major international mergers have taken place in the past five years, including Alcatel-Lucent and Arcelor Mittal. The effects of such unions increase global market correlation because the newly formed companies are known in multiple countries and generate revenues in multiple markets.
You can still profit
These signs seem to point toward one global stock market, where an investor can trade any stock from anywhere in the world at any time. Even though the "free lunch" benefits of international diversification dwindles as this becomes a reality, the growth potential of international stocks remains promising, particularly in emerging markets such as Mexico, Taiwan, and Chile.
The secret is finding these companies early in their growth stages. Early investors in Chinese wireless community NetEase.com, for instance, have seen their shares appreciate 9,810% since March 2002. The thing is, NetEase's rise wasn't a miracle -- it showed the signs of a strong, promising company in 2002. With a founder/CEO with significant ownership at the helm, a strong balance sheet, and a wide market opportunity, NetEase was well-positioned for growth.
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This article was originally published on March 30, 2007. It has been updated.
Fool contributor Todd Wenning wholeheartedly recommends Empire Records to any serious fan of '90s movies. He does not own any shares mentioned in this article. GlaxoSmithKline is a Motley Fool Income Investor pick. Home Depot is an Inside Value selection. NYSE Euronext and NetEase are Rule Breakers choices. The Fool's disclosure policy can't wait for Rex Manning Day.