"When America sneezes, Europe catches the 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 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 move 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 -- 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. NYSE Group recently merged with European market Euronext, creating 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 in order to gain access to foreign capital. Just as some foreign companies appear on U.S. exchanges -- like Canada's Cameco
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 Taiwan and South Africa.
The secret lies in finding these companies early in their growth stages. Early investors in Chinese wireless community NetEase.com, for instance, have seen their shares grow nearly 9,000% since March 2002. But NetEase's rise wasn't a miracle -- it showed the signs of a strong, promising company nearly six years ago. 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.
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.
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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. NASDAQ is a Motley Fool Inside Value pick. NYSE Euronext, Suntech Power, and NetEase.com are Rule Breakers choices. JPMorgan Chase is an Income Investor recommendation. The Fool's disclosure policy can't wait for Rex Manning Day.
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