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In a recent study, we uncovered a puzzling regularity in the fluctuations of stock prices across the markets of different countries. In the United States, and most other developed countries, stocks tend to move in a relatively unsynchronized manner. Ford rises, while GM simultaneously falls, for example. But stocks in emerging markets, like those of Latin America, Asia, and Eastern Europe, exhibit a uniformly different sort of volatility. In contrast to the action in developed countries, stocks in emerging markets tend to move up or down together – en masse. We began by analyzing stock returns data from the first 26 weeks in 1995 to measure the degree of price synchronicity in some representative stock markets. We calculated the fraction of stocks that moved in the same direction in a given country, filtered out those whose prices didn’t move, and charted the number that rose and fell. As seen in Table 1, in emerging markets like China and Poland, over 80% of stocks often moved in the same direction in a given week. For example, in China over 70% of stocks moved in the same direction in 18 weeks. In Poland, 100% of traded stocks moved in the same direction during four of the 26 weeks, and 70% moved in the same direction in 20 weeks. By contrast, Denmark, Ireland, and the United States lacked any instances in which more than 57% of the stocks moved in the same direction during any week. We then correlated the full 1995 year price movements with the size of a country’s per capita Gross Domestic Product between 1992 and 1994. Per capita GDP, of course, is a general measure of economic development. But it can also serve as a proxy for the economic structures and attributes that make up developed economies. And we found that, in general, high-income countries have asynchronous stock prices, with the U.S. having the lowest fraction of stocks moving together. In contrast, low-income economies have higher degrees of price synchronicity, with Poland, China, Taiwan, Malaysia, and Turkey leading the pack. A closer look at the data reveals that the nations we investigated grouped themselves into two data clusters: high-income countries with low synchronicity and low-income countries with high synchronicity. Why should there be such a difference between the fluctuations we see in the stock markets of high and low income countries? We considered several possible explanations. First, firms in low-income countries might have more correlated fundamentals. After all, low-income economies tend to be small, undiversified, subject to unstable macroeconomic policy, and characterized by intercorporate equity cross-holdings. All these factors can turn events that affect one industry into market-wide events. Second, low-income economies usually provide poor and uncertain protection of private property rights. If this reduces the transparency of companies in these countries to investors, the fine tuning of individual companies’ stock prices that we see in developed economy markets might not happen. If so, the stock markets of these countries might be failing in their primary social task, the allocation of capital. We concluded that measures of fundamentals correlation do not explain our finding, but that measures of private property rights protection do. Indeed, variables like market size, country size, economic diversification, macroeconomic policy stability, and intercorporate earnings correlation are, at best, only vaguely related to stock price asynchronicity. The measures of development that are most closely related to stock price asynchronicity are measures of the integrity of government, the efficiency of the judicial system, and the rule of law.
Economic Explanations To determine what explains the highly significant negative correlation between stock price synchronicity and per capita GDP, we investigated which particular development measures are most correlated with stock price synchronicity.
Another factor could be country size. Since economic activity in small countries is geographically localized, nearby geopolitical instability or environmental catastrophes like earthquakes might have market-wide effects that would not be as evident in a larger country. For example, Finland’s economy shrank by 15% in the early 1990s as the neighboring Soviet Union disintegrated and Finland’s role as a gateway to Russia temporarily lost value. In addition, stocks in large countries might move more independently than those in small countries because of industrial and economic diversity. For example, if oil prices fall, the prospects of Ohio manufacturing firms brighten, while those of Texas oil companies dim. In contrast, stocks in a smaller oil-producing country, like Venezuela, might move more synchronously as oil prices change. In some economies, listed firms could be concentrated in just a few industries, which tend to move in sync. And since the stock markets in some economies may be dominated by a few very large companies, a high degree of stock price synchronicity may result if most other listed firms are suppliers or customers of these dominant firms. We tested these factors by constructing indexes to stand as proxies for the variables and by using regression analysis on our data. And we found some intriguing results. For example, price synchronicity is negatively correlated with a country’s geographical size – the bigger the country is, the less likely it is that its stocks move together. We also found that price synchronicity is positively correlated with both GDP growth variance and earnings co-movement. However, these correlations are all statistically insignificant. And we found that greater economic and industrial diversity is not consistently correlated with less stock price synchronicity. So clearly, our basic result cannot be due simply to the fact that low-income countries tend to be small and undiversified. Overall, in fact, these correlations suggest that no one structural variable, on its own, satisfactorily explains the link between per capita GDP and stock price synchronicity. We checked to see if these structural variables, acting in concert, might explain the link. But these results were similarly inconclusive.
Another Explanation: Institutional Development After looking at these economic development measures, we turned to measures of institutional, legal, and political development. In many countries, after all, governments and courts serve as mercantilist devices for diverting wealth to an entrenched elite. Through legislation, licensing requirements, and nationalization, government can inhibit the growth and development of businesses. In these environments, political events, or even rumors about political events, may cause large market-wide stock price swings and generate high levels of stock price synchronicity. Scholar Ray Fisman in 1999 estimated that as much as 25% of the market value of many Indonesian firms was related to political connections. This conclusion was based on an analysis of stock price movements in response to rumors about President Suharto’s health.
But risk arbitrage of this sort may be less economically attractive in countries that protect private property rights more poorly. Economic fundamentals can be obscured by political factors in many low-income countries. Political events may be hard to forecast in low-income nations whose governments are often relatively opaque and erratic. And risk arbitrageurs who do make correct predictions may not be allowed to keep their earnings. Because firm-specific risk arbitrage could be relatively unattractive in such countries, informed trading might be correspondingly thin. If weak property rights discourage informed risk arbitrage, they might also create systematic stock price fluctuations. Scholars believe that an insufficient level of informed trading can “create space” for noise trading – trading that reacts to political events, rumors, and the like. Once the proportion of noise traders in the market rises above a critical level, it might crowd out risk arbitrageurs, who are more risk-averse. As a result, a stock market without a sufficient amount of informed trading could be characterized by large systematic price swings – in other words, greater price synchronicity.
Measuring Good Government If including a measure of good government in our regression analysis renders per capita GDP insignificant, that might be evidence that a lack of property rights protection underlies the high degree of stock price synchronicity. To capture the extent to which a country’s politicians respect private property rights, we constructed a good government index as the sum of three indexes from the International Country Risk Guide (ICR). The “corruption index” is an assessment of corruption in government. Low scores indicate that “high government officials are likely to demand special payments” and that businesspeople may have to pay bribes in order to get import and export licenses, loans, or tax assessments. The “risk of expropriation index” gauges the risk of outright confiscation or forced nationalization. The “repudiation of contracts by government index” measures the risk of a “modification in a contract taking the form of a repudiation, postponement, or scaling down” due to “budget cutbacks, indigenization pressure, a change in government, or a change in government economic and social priorities.”
Haves and Have-Nots Our result leads to a conjecture that the presence of a non-corrupt government that honors and respects private property rights makes it attractive to conduct informed risk arbitrage which results in more informed stock prices. Without an institutional environment that honors property rights, informed risk arbitrage recedes and noise trading generates large systematic swing in all stock prices that is not closely related to economic fundamentals. The “good government” index, however, is a measure of institutional development. It is unlikely to have a fine-grained incremental impact on the matter. Indeed, our data tends to group into two clusters: high-income countries with low stock price synchronicity and low-income countries with high synchronicity. Substituting the good government index for per capita GDP also clearly reveals two clusters. And this clustering suggests the possibility of a threshold effect. If institutional development, as measured by our good government index, is below a critical level, a different regime governs stock prices, and a high degree of synchronicity is observed. We used the mean of the good government index as the dividing line in creating these subsamples, yielding a developed economy group of 22 countries and an emerging economy subsample of 15 countries. Then, we tested whether our results hold within both subsamples, or mainly describe differences between the two subsamples. Among emerging economies, stock market synchronicity is not correlated with either the logarithm of per capita GDP or the good government index. So overall, synchronicity in the emerging markets is generally high but not much worsened by marginal decline in the protection accorded private property. Interestingly, as in our conjecture, higher stock price synchronicity in emerging economies is mainly associated with greater systematic variation. In the developed country subsample, however, the situation is more complex. Synchronicity is marginally higher when the good government index is lower. More importantly, high synchronicity in developed countries is associated both with low levels of firm-specific variation and high levels of market-wide variation. This finding motivates a closer look at the developed countries to clarify the determinants of stock price synchronicity there.
Capitalization of Firm-Specific Information It is possible that a country’s institutions might affect the relative amounts of firm-specific versus market-wide information that are capitalized into stock prices set by rationally informed risk arbitrageurs. In other words, certain attributes might encourage people to place their bets on individual stocks rather than the market as a whole. Our focus is that, unlike in emerging economies, lower synchronicity in developed economies is associated with greater firm-specific variation. In China, for example, the whole market tends to move up or down dramatically, and so stocks move together. By contrast, in the U.S., stocks tend to move more independently of one another. Scholars have concluded that most of the variation in U.S. stock prices reflects the capitalization of proprietary firm-specific information – people processing the data they have about individual companies to influence the stock price. To test these hypotheses, we ran the numbers again using only data from developed countries in our sample. First, we substituted a direct measure of the sophistication of each country’s accounting standards in place of the good government index. The measure was created by scholars based on 1990 data compiled by the Center for International Financial Analysis and Research, Inc. And when we did, it turned out that good accounting standards are negatively correlated with synchronicity. But since the significance levels are in the neighborhood of 20%, the accounting standards index itself is uniformly statistically insignificant. Next, we employed a direct measure of the extent to which public shareholders’ property is protected from appropriation by corporate insiders – the anti-director rights index. This index is a scorecard of shareholders’ rights against directors in various countries. For such rights to provide effective protection, a country must have functional political and legal systems. It is therefore plausible that the anti-director rights index might be relevant only in countries where the rule of law prevails. Notice that among countries with strong property rights protections in general there exists quite a bit of variation in protecting the property rights of public investors against corporate insiders. We therefore ran regressions substituting the anti-director rights index for the good government index. We found that while the anti-director rights index is insignificant in the whole sample and emerging economy subsample, it is negative and highly statistically significant in the developed economy subsample.
Numbing the Invisible Hand? So what do we conclude from these results? Yes, stock returns are more synchronous in emerging economies than in developed economies. But while some economic characteristics may contribute to stock return synchronicity, they don’t entirely explain the outcome. Rather, it seems that the level of institutional development is highly correlated with stock price synchronicity. In particular, less respect for private property by government is associated with more market-wide stock price variation, and therefore also with more synchronous stock price movements. Since these market-wide price fluctuations are uncorrelated with fundamentals, we conjecture that poor property rights protection might deter informed risk arbitrage and noise traders create arbitrary fluctuations. However, we would welcome other possible explanations. In developed economies, providing public shareholders with stronger legal protection against corporate insiders is associated with lower synchronicity. We conjecture that economies that protect public investors’ property rights might discourage intercorporate income-shifting by controlling shareholders. Better property rights protection thus might render risk-arbitrage based on firm-specific information more attractive, which leads to asynchronous stock price movements. Overall, our results suggest that stock markets in emerging economies may be less useful as processors of economic information than stock markets in advanced economies. The function of an efficient stock market is to process information, and thereby guide capital towards its best economic use. But stock price movements in emerging economies are mainly due to either politically driven shifts in property rights or noise trading; numb invisible hands in their stock markets may allocate capital poorly, thereby retarding economic growth.
Randall Morck is Stephen A. Jarislowsky distinguished professor of finance at the University of Alberta. Bernard Yeung is Abraham Krasnoff professor of international business and professor of economics at NYU Stern. This article is adapted from an article in the Journal of Financial Economics, October 2000 Volume 58, pp. 215-260. |
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his
realignment of stock prices and, more importantly, the redirection of
capital flows that it causes, are thought to underlie the growth and prosperity
of modern free market economies. An economy that invests capital in poorly
run or ill-conceived enterprises cannot provide as high a standard of
living as an economy that puts capital where it is most useful. That this
mechanism works well is a prime argument by those who oppose government
intervention in the economy. That stock fluctuations are a meaningless
throw of dice is a prime argument made by those who mistrust capitalism
and all it stands for.
irst,
we considered several possible economic explanations. The negative correlation
between stock price co-movement and per capita income could be due to
the fact that the companies in low-income economies tend to have more
correlated economic fundamentals. Or, it could be that unstable market
fundamentals are caused by macro-economic instability – erratic
or unpredictable growth. In such economies, volatile market fundamentals
may overwhelm variations due to firm-specific factors, so that stock
prices tend to move together.
ndeed,
bad government might increase stock price synchronicity through channels
that are not directly associated with economic fundamentals, like corporate
earnings or GDP. Finance theory holds that professional investors –
risk arbitrageurs – expend resources to uncover proprietary information
about stocks and earn an acceptable return by using that information
to trade against less-informed investors. Such trading by many risk
arbitrageurs, each possessing unique proprietary information, is thought
to capitalize information into share prices of individual companies.
e
considered two factors that might make firm-specific risk arbitrage
more attractive in economies: (1) better accounting data; and (2) better
protection for public investors from corporate insiders. If accounting
data are more useful, more firm-specific public information is available
to all investors. And that may let risk arbitrageurs make more precise
predictions regarding firm-specific stock price movements. A lack of
respect for the property rights of public investors by controlling shareholders
might discourage risk arbitrage based on firm-level information and
hence impedes the capitalization of firm-level information in stock
prices in some developed countries.