Say Goodbye to Your Free Lunch

"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 our 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 nearly 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 effects on the markets. Just four years ago, an uprising in Nigeria sent oil prices above $50 for the first time, and the event roiled the global markets for a few days.

The move toward highly correlated global markets has become a reality in a very short period of time. According to a 2007 article in The Economist, international markets have revealed a 95% correlation with the S&P 500 -- a figure that once sat as low as 40% in the mid-1990s!

In other words, the global markets are dancing in step more than ever before. 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. In 2006, the NYSE Group merged with European market Euronext, to create 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." Indeed, NASDAQ Stock Market's recent acquisition of Nordic exchange owner OMX is further evidence of this trend.

Furthermore, many companies are listed in multiple global markets to gain access to foreign capital. Just as some foreign companies appear on U.S. exchanges -- such as Canada's Potash  (NYSE: POT  ) and China's PetroChina -- U.S. companies such as Caterpillar (NYSE: CAT  ) and Applied Materials (Nasdaq: AMAT  ) are listed on the Frankfurt and London exchanges.

Finally, international mergers have been frequent in the past five years, including Luxembourg-based Tenaris' (NYSE: TS  )  purchase of U.S. firm Hydril in April and Alcatel-Lucent back in December 2006. In more recent news, Swiss tech firm STMicroelectronics NY (NYSE: STM  ) completed its purchase of U.S.-based Genesis Microchip (Nasdaq: GNSS  ) . 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 often overlooked emerging markets such as Taiwan, Chile, and Mexico.

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 nearly 9,700% 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 who has significant ownership, plus a strong balance sheet and a wide market opportunity, NetEase was well positioned for growth.

Need some help finding a few good international stocks? Fool senior analyst Bill Mann and the Motley Fool Global Gains team are a great resource -- they take the time to explain the intricacies of the global markets and teach you what to look for and what to avoid. You can see all of their past recommendations and receive two new stock ideas each month with a free 30-day trial to Global Gains. Simply click here to take advantage of our offer.

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. NASDAQ is a Motley Fool Inside Value pick. NYSE Euronext and NetEase.com are Rule Breakers choices. The Fool's disclosure policy can't wait for Rex Manning Day.


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