Sentiment Is Increasing Foreign Market Correlations

Correlations between international financial markets have been increasing over time, due to non-fundamental factors. A key characteristic of these factors is investor sentiment.

Correlations between international financial markets have been increasing over time. This increase is not being caused by fundamental factors, but rather by non-fundamental factors. A key characteristic of these non-fundamental factors is investor sentiment.

Three researchers reached this conclusion after analyzing data on five countries: the United States, the United Kingdom, Japan, Australia and France. These countries were chosen based on the availability of data, the importance of their markets and their geographic dispersion. Correlations between the U.S. and the other four countries have typically increased from 25% in the 1950s to 80% in recent years.

Authors Bart Frijns et al. say the increased comovements among the markets are not due to fundamental factors. As such, they argue that globalization and economic integration may not be the driving force. Rather, sentiment-driven traders are the more likely cause.

Sentiment could cross markets via two mechanisms. First, increased globalization and more global spread of news could make sentiment more of a global phenomenon. Second, to the extent that investors diversify globally, sentiment based on their local markets could influence how they feel about conditions in foreign markets.

The authors acknowledge the difficulty of assessing investor sentiment. This is particularly the case in most of the countries they looked at. They did find the U.S. sentiment (as measured by the AAII Sentiment Survey) to be a useful proxy, however. Previous research has found a high correlation between U.S. and global sentiment. Plus, U.S. sentiment measures have been found to be very useful in explaining U.K. and French market returns.

Their analysis found that the correlation between the AAII Sentiment Survey results and returns “is positive and large.” They further found a “strong and positive relation with non-fundamental returns.” As such, they concluded that investor sentiment has “a significant direct effect on the return and the variance” and also on the covariance between countries.

Investor sentiment in the U.S. was not found to influence the fundamentals of other countries. It can be related to fundamentals to the extent that positive fundamental news both impacts total returns and spills over to sentiment.

Source: “Excess Stock Returns Comovements and the Role of Investor Sentiment,” Bart Frijns, Willem F.C. Verschoor and Remco C.J. Zwinkels, Accepted manuscript for the Journal of International Financial Markets, Institutions and Money.