The authors find that the increased correlations between stock markets of different countries are driven mainly by nonfundamental, sentiment-driven factors and not by fundamental factors. Unlike the Great Depression of the 1930s, which was the result of fundamental factors, both the dot-com bubble and the credit crisis were most likely driven by investor sentiment.

Whenever investors expand their portfolios to include new assets, demand for those assets increases and they become more correlated with the assets already in the portfolio. Historical empirical evidence suggests that a stock’s beta increases when it joins the S&P 500 Index. A large part of this increase is driven not by fundamental factors but, rather, by investor sentiment.

Such factors as globalization and economic integration are not the driving forces behind the increase in comovements of international financial markets. While the correlations between the US stock market and the stock markets of other developed nations have increased from 25% in the 1950s to 80% recently, the conditional correlations between fundamental factors are well below 50% and do not indicate any trend. As investors have broadened their investment universe, investor sentiment in domestic markets has begun to affect international markets, leading to excess (i.e., nonfundamental) stock return comovements.

All data are from Global Financial Data. The authors use monthly total return indexes, along with dividend yields and exchange rates against the US dollar. They use country indexes through the year 2009 for the United States (beginning in 1871), the United Kingdom (1924), Japan (1949), Australia (1882), and France (1941).

The authors construct a fundamental value for equity using the dividend discount model; the returns not covered by this fundamental portion are labeled nonfundamental returns. Once the fundamental returns have been established using Gordon’s growth formula, the rest of the returns are attributed to nonfundamental factors.

They also construct a generalized autoregressive conditional heteroskedasticity (GARCH) model to disentangle the different factors causing excess return comovements. They test their results using the American Association of Individual Investors Sentiment Index to proxy “noise” traders, who cause excess volatility, and the likelihood ratio test.

A graph of log prices and fundamental prices shows that the indexes for the five countries oscillate around their fundamental values except for Japan, whose actual prices remain above the fundamental prices starting in 1950, reflecting negative correlation. The average growth values of the fundamental returns coincide with those of the market itself, suggesting a reasonable proxy for the fundamental price.

The authors construct a behavioral model that shows that the covariance between two markets can be driven by (1) the covariance between fundamental values and (2) the covariance between changes in sentiment.

The analysis shows that the correlations between international market returns are statistically significant and vary from 27% between the United States and Japan to 51.4% between the United Kingdom and Australia. Although the fundamental correlations between countries are low and mostly insignificant, the nonfundamental sentiment correlations are high and significant.

Using the BEKK model over the same sample period, the authors determine that the comovements between two markets are most likely because of sentiment-driven traders.

The authors’ findings show that the increase in comovements is observed only in nonfundamental returns (i.e., sentiment returns) and not in fundamental returns. The increase in comovements between international stock markets is driven by the correlated demand of sentiment-driven investors who have broadened their investment universe to include more international assets.

As more and more investors begin to add international assets to their portfolios, their home market sentiment starts to affect the returns of foreign assets, leading to an increase in correlations between international and domestic markets and reduced diversification benefits. As more investors become global investors, the diversification benefits they used to receive decrease. Because of this loss of diversification benefits, investors are now motivated to shift away from traditional geographic diversification to seek out other dimensions of diversification—for example, factor- or industry-based diversification.