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Stock prices move together more in poor economies than in rich economies. This finding is not due to market size and is only partially explained by higher fundamentals correlation in low-income economies. However, measures of property rights do explain this difference. The systematic component of returns variation is large in emerging markets, and appears unrelated to fundamentals co-movement, consistent with noise trader risk. Among developed economy stock markets, higher firm-specific returns variation is associated with stronger public investor property rights. We propose that strong property rights promote informed arbitrage, which capitalizes detailed firm-specific information.

Stock returns reflect new market-level and firm-level information. As Roll (1988) makes clear, the extent to which stocks move together depends on the relative amounts of firm-level and market-level information capitalized into stock prices. We find that stock prices in economies with high per capita gross domestic product (GDP) move in a relatively unsynchronized manner. In contrast, stock prices in low per capita GDP economies tend to move up or down together. A time series of stock price synchronicity for the U.S. market also shows that the degree of co-movement in U.S. stock prices has declined, more or less steadily, during the 20th century. These findings are not due to differences in market size or economy size.1 We consider three plausible explanations for our finding. First, firms in low-income countries might have more correlated fundamentals, and this correlation might make their stock prices move more synchronously. For example, if low-income economies tend to be undiversified, firm-level earnings may be highly correlated because industry events are essentially market-wide events. Second, low-income economies often provide poor and uncertain protection of private property rights. Political events and rumors in such countries could, by themselves, cause market-wide stock price swings. Moreover, inadequate protection for property rights could make informed risk arbitrage in their stock markets unattractive. According to De Long et al., 1989 and De Long et al., 1990, a reduction in informed trading can increase market-wide noise trader risk, which we would observe as increased market-wide stock price variation unrelated to fundamentals. Third, in countries that provide poorer protection for public investors from corporate insiders, problems such as intercorporate income shifting could make firm-specific information less useful to risk arbitrageurs, and therefore impede the capitalization of firm-specific information into stock prices. This effect would reduce firm-specific stock price variation, again increasing stock return synchronicity. We reject the first hypothesis, and find some evidence consistent with the second and third hypotheses stated above. Our formal statistical analysis shows that economies with more correlated fundamentals do have stock markets with more synchronous returns, but our best efforts to control for fundamentals correlation and volatility do not render per capita GDP insignificant. Adding a variable that measures government respect for private property, however, does render per capita GDP insignificant in explaining stock price synchronicity. Finally, among developed economies, more protection of public shareholders’ property rights against corporate insiders is correlated with more firm-specific information being capitalized into stock prices. We conjecture that the degree to which a country protects private property rights affects both the extent to which information is capitalized into stock prices and the sort of information that is capitalized. While our econometric evidence is consistent with this conjecture, we recognize that our explanation is incomplete. We invite alternative explanations of our empirical finding that stock returns are synchronous in low-income economies and asynchronous in high-income economies. Any such explanations must be consistent with our findings that market size, economy size, and many aspects of fundamentals volatility do not affect the relation between per capita GDP and synchronicity, but that measures of property rights protection render per capita GDP insignificant in explaining stock price synchronicity. In the next section, we review the empirical regularities that motivate this research. In Section 3, we develop our basic synchronicity measures and show their negative relationship with per capita GDP. In Section 4, we discuss our empirical framework and the dependent variables we adopt. In the fifth, sixth and seventh sections, we present our hypotheses and empirical specifications, report our results, and conduct various robustness checks. In Section 8, we present conclusions.

We present empirical evidence that stock returns are more synchronous in emerging economies than in developed economies. We show that this result is not an artifact of structural characteristics of economies, such as market size, fundamentals volatility, country size, economy diversification, or the co-movement of firm-level fundamentals. Though some of these factors contribute to stock return synchronicity, a large residual effect remains, and this effect is correlated with measures of institutional development. 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 risk arbitrage and, in the words of De Long et al. (1990), “create space” for noise traders. However, since we may be controlling for fundamentals volatility imperfectly, we cannot rule out other explanations. We also show that, in developed economies, providing public shareholders with stronger legal protection against corporate insiders is associated greater firm-specific returns varition, and so 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 firm-specific risk-arbitrage more attractive in the stock markets of such economies. 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. If 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. Consistent with this interpretation, Wurgler (2000) finds a higher elasticity of capital expenditure with respect to value added in countries whose stock returns are less synchronous, as measured in this study. Finally, we recognize that these interpretations, though supported to some extent by our findings, remain conjectures. We invite alternative explanations of our econometric findings.