Stock markets are approaching bubble territory

Key benchmark stock indices have increasingly begun moving in tandem

Six years after the great financial crash shook the world, equity markets are beginning to behave as they did in the run-up to the crisis. One of the hallmarks of the bubble that blew up in 2008 and the crash that followed was the heightened tendency of stocks across the globe to rise and fall in tandem. Something similar is beginning to happen across stock markets globally, indicating that they could be headed towards bubble territory.

The years 2008 and 2009 saw benchmark equity indices move in perfect sync with each other. The correlation coefficient between the Dow Jones Industrial Average (DJIA) and the Sensex was 0.97 in both years (correlation coefficient is a measure of association, with values close to 1 indicating high correlation and values close to 0 indicating low correlation). The correlation coefficient between the DJIA and the MSCI Emerging Markets Index was 0.95 in both 2008 and 2009. Since then, the correlation coefficient had dropped over the years. In 2013, the correlation coefficient between Sensex and DJIA dropped to 0.48, while that between DJIA and the MSCI Emerging Markets Index turned negative.

That disassociation between key benchmark indices seems to have ended this year, with equity indices once again moving in lockstep with each other. The correlation coefficient between the DJIA and the Sensex has moved up to 0.90; so has the correlation between DJIA and the MSCI Emerging Markets Index. To be sure, there are markets such as China, which are not as tightly correlated to the US and other emerging markets in 2014 as they were in 2008 but the broad trend is hard to dismiss. Most emerging markets have become extremely correlated with US markets, and are more vulnerable to a global selloff than at the start of the year.

Alarm bells have already begun ringing. In a recent report, the International Institute of Finance said the world should prepare for a spike in financial market volatility as well as a correction in asset valuation. Earlier, in its annual report published on 29 June, the Bank of International Settlements (BIS) warned about rising financial exuberance and the “puzzling disconnect between the markets’ buoyancy and underlying economic developments globally".

“In a number of economies that escaped the worst effects of the financial crisis, growth has been spurred by strong financial booms," the BIS report said. “Policy in those economies needs to put more emphasis on curbing the booms and building the strength to cope with a possible bust, and there, too, it cannot afford to put structural reforms on the back burner."

India and other emerging markets will do well to pay heed to these words of wisdom.