Faculty Scholarship 1994 - Present

Co-Movements of the US and EU Stock Markets

The present European Union (EU) has its roots in the earlier European Coal and Steel Community (ECSC, founded in 1951) and the European Economic Community (EEC, established in 1958 following the Treaty of Rome 1957). The six founding members, Belgium, France, Italy, the Netherlands, Luxembourg, and West Germany, were joined by Britain, Denmark, and Ireland in 1973. Other early members include Greece (joined in 1981), and Spain and Portugal (joining in 1985). The 13 newest member states and their year of joining the EU are Austria, Finland, and Sweden (1995), and Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia (2005). In addition, Bulgaria and Romania are set to join at the beginning of 2007. The member states of the EU are independent, sovereign nations. They pool their sovereignty in order to gain a strength and world influence none of them could have on their own. This means the member states delegate some of their decision-making powers to shared institutions. While the overall vitality of the EU rests on its major institutions; the European Parliament, Council of the European Union, European Commission, Court of Justice, and the Court of Auditors; it is the European Investment Bank (and European Investment Fund, which it administers) and European Central Bank, which set and administer policies, most likely to affect the EU stock markets studied in this paper. The U.S. is the largest country studied in terms of population (295,734,134) and GNP ($11.75 trillion) and has the second highest economic growth rate (4.4%) of the 15 countries. Germany is the second largest country in terms of population (82,431,390) followed by France (60,656,178) and the U.K. (60,441,457). Germany also has the second largest economy in terms of GNP (2.362 trillion) followed by the U.K. ($1.782 trillion), France (1.737 trillion), and Italy ($1.609 trillion). Ireland is the smallest country in terms of population (4,015,676) and GNP (126.4 billion) but has the highest growth rate in GNP (5.1%) followed in Europe by Greece (3.7%), and the U.K. (3.2%). Noteworthy are the low growth rates in population among all European countries that range from a low in Germany of 0% to a high in Ireland of 1.16%. The U.S. has the second highest population growth rate at 0.92%. Germany ($893.3 billion) is the largest exporter, followed by the U.S. ($795 billion), France ($419 billion), the U.K. ($347.2 billion), and Italy ($336.43 billion). Greece is the smallest exporter ($15.5 billion). The U.S. is the largest importer of all countries studied ($1.476 trillion) followed by Germany (716.7 billion), the U.K. (439.4 billion), France (419.7 billion), and Italy (329.3 billion). Finland is the smallest importer ($45.17 billion). The U.S. trade deficit ($681 billion) is larger than any other country in the study. Germany has the largest trade surplus ($176.6 billion). The U.S., France, Greece, Portugal, Spain, and the U.K. have a trade deficit and Austria, Belgium, Denmark, Finland, Germany, Ireland, Italy, the Netherlands, and Sweden have a trade surplus. The co-movements of the world�s national stock market index returns have long been a popular research topic in the finance literature. Although the co-movements of the world�s major stock markets have been extensively studied, the co-movements of the stock markets in a common market have not received sufficient attention. In this paper, we study the co-movements of fourteen EU stock markets during the June 1995-May 2005 period. To derive global portfolio diversification insights for U.S. investors, the U.S. stock market is also included in the study. We use the Morgan Stanley Capital International (MSCI) weekly U.S.-dollar stock market indexes in the analysis. The index data are drawn from the Datastream database. The weekly index returns are computed as the natural log difference in the indexes, ln (Ii,t/ Ii, t-l). The weekly average index returns of the fifteen stock markets and the volatilities of the returns are compared. We use the rolling correlation analysis technique to study the time-varying correlation between the U.S., French, German, and U.K. weekly stock market index returns, the four largest stock markets covered in the study. The principal components analysis (PCA) technique is used to study the co-movements of the fifteen stock markets. The stock markets are grouped into statistically significant principal components in terms of similarities of their index return movements. The Granger-causality test is used to determine if the weekly index returns of the fifteen stock markets fallow a random walk, i.e., if they are weak-form efficient. The lead/lag relations between the markets are studied to determine if the past returns of some markets can be used to predict the future returns of other markets. The time-varying rolling correlation analysis results indicate that correlation between the U.S., French, German, and U.K. stock markets has increased sharply during the June 1995-May 2005 period. It implies that the portfolio diversification benefit to global investors in these four major stock markets has decreased sharply during this period. The principal components analysis technique has grouped the fifteen stock markets into two statistically significant principal components in terms of the similarities of their weekly index return movements. The U.S., Finnish, Swedish, German, French, Dutch, U.K., Italian, and Danish stock markets have higher factor loadings in the first principal component. The Austrian, Portuguese, Belgium, Greek, Spanish, and Irish stock markets have higher factor loadings in the second principal component. The stock markets with high factor loadings in the same principal component are highly correlated and investing in these stock markets would provide limited diversification benefit to global investors. The Granger-causality test results reveal significant lead/lag relations between the fifteen stock markets. The weekly index returns of the U.S. stock market lead (can predict) the weekly index returns of the Austrian, Danish, Dutch, German, Irish, Spanish, and Swedish stock markets. Similarly, the weekly index returns of the U.S. stock market can be predicted by the weekly index returns of the Danish, Dutch, Finnish, Portuguese, and U.K. stock markets. To maximize the portfolio diversification benefit, U.S. investors should avoid investing in the EU stock markets with significant lead/lag linkages with the U.S. stock market. Although they are relatively small in size, the weekly index returns of the Danish, Finnish, and Portuguese stock markets lead the weekly index returns of many other stock markets, i.e., the weekly index returns of these stock markets can be used to predict the weekly index returns of many other stock markets. The weekly index returns of the French, German, and U.K. stock markets also appear to have a significant lead role. However, the weekly index returns of the Austrian, Belgian, Greek, Irish, Italian, and Swedish stock markets do not lead the weekly index returns of any other stock market, i.e., the weekly index returns of these stock markets cannot predict the weekly index returns of any other stock market.