Journal of Banking and Finance 13 (1989) 627-640.

North-Holland

POTENTIAL GAINS FROM INTERNATIONAL PORTFOLIO

DIVERSIFICATION AND INTER-TEMPORAL STABILITY AND
SEASONALITY IN INTERNATIONAL STOCK MARKET
RELATIONSHIPS

Ilhan MERIC
Rider College, Lawrenceville, NJ 08648, USA

Gulser MERIC”
Glassboro State College, Glassboro, NJ 08028, USA

Received October 1988

In this paper, we find empirical evidence that diversification across countries results in greater
risk reduction than diversification across industries. Our inter-temporal stability tests indicate
that, the longer the time period considered, the better proxies ex post patterns of co-movement
can be for the ex ante co-movements of international stock markets. Our seasonality tests show
that international stock market co-movements are stable in the September-May period, but
relatively unstable in the May-September period.

1. Introduction

International portfolio diversification has been a popular research topic in

finance literature. Low correlations among national stock markets have been
often presented as evidence in support of the potential gains to investors
from international diversification [see Levy and Sarnat (1970), Solnik (1974)
and Watson (1978)]. In order to realize the potential gains from inter-
national diversification, investors must be able to predict the future co-
movements of national stock markets. Ex post patterns of co-movement may
be useful proxies for the ex ante co-movements. However, the use of ex post
co-movement patterns as proxies for the ex ante relationships is only feasible
if the observed structural relationships are stable over time. The inter-
temporal stability of international stock market relationships has been
analyzed in several previous studies with conflicting results.
*The authors would like to thank Caryl Dix and Linda Feeney for their computer assistance.
Ilhan Merit acknowledges financial support from Rider College. This paper was presented at the
15th annual meeting of the European Rnance Association, Istanbul, Turkey, September 1-3,
1988.

03784266/89/$3.50 0 1989, Elsevier Science Publishers B.V. (North-Holland)

628 I. Merit and G. Merit, international portfolio diversijkation

Several studies have found no empirical evidence in support of inter-

temporal stability in international stock market relationships. Makridakis
and Wheelwright (1974) analyzed the short-term stability of the relationships
among 14 international stock market indices by applying principal compo-
nents analysis and regression analysis to daily data for the January 5, 1968-
September 30, 1970 period. They concluded that the co-movements of
international stock exchanges are random processes. In a similar study,
Hillard (1979) determined that no significant leads or lags exist among the
stock market indices of 8 major industrial countries by applying spectral
analysis to daily data for the July 7, 1973-April 30, 1974 period. Maldonado
and Sounders (1981) employed the Box-Jenkins technique to the monthly
stock market data of the United States and 4 other major industrial
countries for the 1957-1978 period. They found the inter-country correlations
for periods longer than two quarters to be generally unstable and concluded
that it is not possible to reject the hypothesis that the correlations follow a
random walk. Haney and Lloyd (1978) applied standard correlation analysis
to the monthly stock market data of 22 countries for the January 1966June
1975 period. They concluded that international events, such as changes in
exchange-rate systems, can significantly change international stock market
relationships.
Several other studies, however, have found empirical evidence in support
of inter-temporal stability in international stock market co-movements,
Watson (1980) applied standard correlation analysis and regression analysis
to the monthly stock market indices of 8 countries for the 197&1977 period.
He concluded that inter-temporal stability exists in international stock
market relationships over one-year, two-year, and four-year time periods.
Panton, Lessig, and Joy (1976) used weekly data for the 1963-1973 period
and cluster analysis to test the inter-temporal stability of relationships among
12 national stock markets. They found considerable one-year, three-year, and
ten-year stability. Philippatos, Christoli, and Christofi (1983) employed the
Box-Jenkins technique and principal components analysis to determine if
inter-temporal stability existed among the monthly stock market indices of
14 industrial countries in the 1959-1978 period. They found a strong
empirical support for the hypothesis of non-randomness and for the existence
of stability in the inter-temporal relationships among the national stock
market indices of the industrialized world.
The first objective of this paper is to provide new empirical evidence on
the controversial inter-temporal stability issue by using data for a more
recent time period, a different data base, and a different statistical methodo-
logy. The most recent time period covered in previous studies is the 1959-
1978 period [see Philippatos, Christofi and Christoti (1983)]. Our study
covers the 1973-1987 period which should reveal the patterns of more recent
relationships among international stock markets. In previous tests of inter-
 I. Merit and G. Merit, International portfolio diversification 629

temporal stability, different data bases such as IMF International Financial

Statistics, United Nations Monthly Bulletin of Statistics, Baron’s, and daily
financial newspapers have been used. Morgan Stanley Capital International
Perspective (MSCIP) monthly statistics are used in this study. Finally, in
previous studies, the inter-temporal stability of individual correlation coeffi-
cients has been studied and the inter-temporal stability of the correlation
matrix has been overlooked. In this study, by using Box’s M statistical tests
for the equality of matrices [see Box (1949)], we test the inter-temporal
stability of the matrix of correlation coefficients among the stock markets of
17 countries.
Stock market seasonality has been another popular research topic in
finance literature. Rozeff and Kinney (1976), Tinic and West (1984), Brown,
Keim, Kleidon, and Marsh (1983), and Gultekin and Gultekin (1983) have
studied seasonality in various national stock markets of the world. However,
no attempt has been made in previous studies to analyze seasonality in
international stock market relationships. The second objective of our paper is
to use Box’s M methodology to test if there is seasonality in international
stock market co-movements. This methodology was also used by Cho and
Taylor (1987) in a recent article to test if the correlation and variance-
covariance matrices of NYSE and AMEX stocks differ across calendar
months.
Finally, with the exception of two articles by Lessard (1974, 1976), in
previous studies investigating the potential benefits of international diversiti-
cation, the emphasis has been on the co-movements of international stock
markets and the co-movements of international industry portfolios have not
been considered. Along with national stock market indices, MSCIP also
publishes monthly indices for international industry portfolios which incor-
porate the same stocks as the national stock market indices. This provides a
valuable opportunity to study the potential benefits of international portfolio
diversification by comparing information obtained from the national stock
market indices and the international industry indices. The third objective of
our paper is to undertake such an analysis.
The remainder of our paper is organized as follows: section 2 describes
Box’s M methodology and the MSCIP data. Section 3 analyzes the potential
gains from international diversification by studying the relationships between
national stock market and international industry portfolios. The inter-
temporal stability tests are presented in section 4. The seasonality tests are
presented in section 5. Section 6 concludes the paper.

2. Methodology and data

Box’s M is a standard test statistic for the multiple discriminant analysis

(MDA) and multivariate analysis of variance (MANOVA) programs in the
630 I. Merit and G. Merit, International portfolio diver#cation

SPSSX computer package to test the equality of the variance-covariance

matrices of two or more groups. However, it has never been used to test the
inter-temporal stability of the matrix of correlation coefficients among
national stock market indices. This study is an attempt to use Box’s M
statistical tests for this specific purpose
Box’s M statistic is calculated as follows:

M=k i (ni-l)lnlC;lCI, where

i=l

c= & i$l(ni-l)Ci

Ci is the i’th year’s (or month’s) correlation matrix. g is the number of years
(or months) whose correlation matrices are compared. u is the number of
variables in the correlation matrices. ni is the number of observations for the
i’th year (or month) and N is the sum of observations for all years (or
months) compared. C has a chi-square distribution with V(U+ l)(g- 1)/2
degrees of freedom.
Stock market indices used in this study are taken from Morgan Stanley
Capital International Perspective (MSCIP) publications. These statistics were
also used in two recent studies by Gultekin (1983), and Gultekin and
Gultekin (1983) to analyze the effects of inflation and seasonality on
international stock market returns. MSCIP indices are based on approxima-
tely 1,200 companies listed on the stock exchanges of 19 countries. The
combined market capitalization of these companies represents approximately
60 percent of the total market value of all stocks traded on the stock
exchanges of these countries.
MSCIP indices are based on month-end closing prices in local currencies.
Exchange-rate-adjusted monthly return relatives for each country are calcu-
lated as follows:

xi, -Iit+1 xxi,,

Iit Xit+ 1

Ri, = The exchange-rate-adjusted return

relative for country i in month t.
Ii, =The stock market index for country i
in month t.
Xi, = Country i’s exchange rate in terms
of U.S. dollar in month t.
 I. Merit and G. Merit, International portfolio diverkjkation 631

MSCIP publishes quarterly and monthly indices. The analysis in this

paper is based on the monthly indices. Stock prices are very volatile and
show rapid responses to international developments. Therefore, monthly data
can provide more accurate information about the behavior of stock market
indices than can quarterly data. Furthermore, a month is a sufficiently long
time period so that several-day leads or lags in international stock market
relationships will not obscure the co-movements of the indices.
The exchange-rate-adjusted MSCIP indices have been published since
January 1973. Therefore, the January 1973-December 1987 period is studied
in this paper. A 15-year period should be sufficiently long to derive
conclusions about the long-term co-movement patterns of international stock
markets.
Box’s M statistical tests are applied to the correlation matrices of 17
countries for the consecutive 1.5-year, 3-year, 5-year, and 7.5-year time
periods to test the inter-temporal stability of international stock market co-
movements. Box’s M tests are also applied to the monthly correlation
matrices of 14 countries to test seasonality in international stock market
relationships. Since the number of variables must be less than the number of
observations, only 17 country indices are used in the inter-temporal stability
tests and 14 country indices are used in the seasonality tests.
MSCIP also publishes monthly indices for 38 international industry stock
portfolios which incorporate the same stocks included in the national stock
market indices. Some of the 38 industries have been added to the list in
recent years. Indices for only 21 of these 38 industries have been published
regularly during the entire 15-year period. Our study uses 17 of these 21
industries.
SPSSX-Principal Components Analysis program is used to obtain the
correlation matrices and to factor-analyze the co-movement patterns of the
international stock market and industry indices. SPSSX-MANOVA program
is used for Box’s M inter-temporal stability and seasonality tests.

3. International stock market and industry relationships and international

portfolio diversification

3. I. Dependency (or independency) indices

The degree of dependency (or independency) of a country’s stock market

on (or from) the stock markets of other countries can be determined by
calculating what may be called a dependency (or independency) index. This
index is an average of the correlation coefficients between a country’s stock
market index and the stock market indices of other countries. The depen-
dency (or independency) indices of the 17 national stock markets covered by
our study are presented in table 1. The most dependent (or most open) stock
632 I. Merit and G. Merit, International portfolio diversijcation

Table 1
Dependency (independency) indices of national stock markets
(1973-1987).

Average correlation coefficient with

National stock markets the other countries=
(Most dependent-Most open)
(1) Netherlands 0.523
(2) Switzerland 0.518
(3) Belgium 0.488
(4) France 0.464
(5) U.K. 0.442
(6) Germany 0.435
(7) U.S.A. 0.413
(8) Canada 0.411
(9) Norway 0.385
(10) Australia 0.381
(11) Sweden 0.371
(12) Singapore 0.354
(13) Japan 0.335
(14) Hong Kong 0.317
(15) Austria 0.314
(16) Italy 0.307
(17) Spain 0.300
(Most independent-Most isolated)
Average 0.398
“All correlation coefficients are significant at 1 percent signifi-
cance level.

market in the world belongs to Netherlands. The most independent (or most
isolated) stock market in the sample is that of Spain.
The industry dependency (or independency) indices based on the correla-
tions among the 17 international industry portfolios used in our study are
presented in table 2. The most dependent industry in the sample is the
building materials industry and the most independent industry appears to be
the airlines industry.
Since MSCIP country and industry indices incorporate the same stocks,
the correlation coefficients in tables 1 and 2 can be used to compare the
potential benefits of international diversification across countries and across
industries. The average correlation coefficient in table 1 is substantially lower
than the average correlation coefficient in table 2. This indicates that there is
more to be gained by diversifying across countries given industrial diversifi-
cation within a single country than by diversifying across industries given
diversification across countries.

3.2. Volatility of returns

The coefficient of variation figures measuring the degree of volatility of
monthly national stock market return relatives are presented in table 3.
Spain’s stock market appears to be the most volatile in the sample. The
 I. Merit and G. Merit, International portfolio dioersijkation 633

Table 2
Dependency (independency) indices for international industry portfolios
(1973-1987)

Average correlation coefticient with

International industry portfolios the other industries”
(Most dependent)
(1) Building materials 0.719
(2) Chemicals 0.713
(3) Machinery 0.691
(4) Electrical & electronics 0.688
(5) Insurance 0.679
(6) Food & household products 0.676
(7) Textiles and apparel 0.658
(8) Forest products 0.653
(9) Merchandising 0.650
(10) Health & personal care 0.640
(11) Automobiles 0.596
(12) Banking 0.577
(13) Appliances 0.575
(14) Non-ferrous metals 0.541
(15) Steel 0.509
(16) Energy 0.496
(17) Anlines 0.458
(Most independent)
Average 0.619
“All correlation coefficients are significant at 1 percent significance level.

Table 3
Volatility of national stock market return relatives
(1973-1987)

National stock markets Coefficients of variation

(Most volatile)
(1) Spain 39.910
(2) Singapore 13.609
(3) Australia 11.423
(4) U.S.A. 10.821
(5) Canada 10.788
(6) Hong Kong 10.732
(7) Italy 9.483
(8) Norway 9.110
(9) France 8.850
(10) U.K. 8.675
(11) Belgium 8.639
(12) Austria 7.073
(13) Germany 6.852
(14) Switzerland 6.674
(15) Netherlands 6.072
(16) Sweden 5.673
(17) Japan 4.064
(Least volatile)
Average 10.497
634 1. Merit and G. Merit, International portfolio diversification

Table 4
Volatility of international industry portfolio return relatives
(1973-1987)

International industry portfolios Coefficients of variation

(Most volatile)
(1) Non-ferrous metals 12.588
(2) Forest products 10.585
(3) Merchandising 10.280
(4) Energy 8.749
(5) Machinery 8.396
(6) Steel 8.349
(7) Health & personal care 7.645
(8) Textiles & apparel 6.977
(9) Appliances 6.759
(10) Building materials 6.588
(11) Automobiles 6.177
(12) Airlines 6.154
(13) Chemicals 5.965
(14) Insurance 5.541
(15) Electrical & electronics 5.291
(16) Food & household products 5.234
(17) Banking 5.215
(Least volatile)
Average 7.442

national stock market with the lowest volatility in the sample is that of
Japan.
The coefficient of variation figures for the international industry portfolios
are presented in table 4. Among the industries covered by our study, the
non-ferrous metals industry has the most volatility and the banking industry
has the least volatility.
A comparison of the coefficient of variation figures in tables 3 and 4 shows
the benefits of international portfolio diversification across countries. The
average coefficient of variation of country return relatives in table 3 is
substantially greater than the average coefficient of variation of international
industry portfolio return relatives in table 4. This indicates that diversifi-
cation across countries, even if within a single industry, results in greater risk
reduction than diversification across industries within countries.

3.3. Principal components

The correlation coefficient measures the extent to which two statistical
series move together. However, if the objective is to analyze patterns of
movement common to several statistical series, factor analysis, a multivariate
statistical technique, can be a useful tool. In this section of the paper,
principal components analysis, a special form of factor analysis, is used to
 I. Merit and G. Merit, International portfolio diversification 635

Table 5
Principal components with national stock market indices (1973-1987)

Principal components
First Second Third Fourth
National principal principal principal principal
stock markets component component component component
Germany 0.837 0.133 0.151 0.154
Austria 0.767 - 0.008 0.181 0.063
Switzerland 0.720 0.371 0.167 0.203
Netherlands 0.683 0.457 0.134 0.183
Belgium 0.651 0.373 0.331 0.036
Canada 0.076 0.784 0.173 0.203
U.S.A. 0.186 0.719 - 0.026 0.322
Norway 0.374 0.658 0.092 - 0.003
U.K. 0.273 0.591 0.307 0.122
Italy 0.160 0.223 0.674 0.034
Spain 0.188 0.086 0.656 0.001
Japan 0.380 - 0.077 0.610 0.404
Hong Kong 0.195 0.114 0.098 0.796
Singapore 0.108 0.339 0.019 0.716
Sweden 0.392 0.347 0.166 0.225
France 0.420 0.458 0.45 1 - 0.043
Australia - 0.059 0.493 0.466 0.373
Variance explained by
each principal component 40.1% 9.2% 6.4% 6.3%
Cumulative
variance explained 40.1% 49.4% 55.8% 62.0%

analyze patterns of covariance among the 17 national stock market indices

and among the 17 international industry portfolio indices.
To eliminate first-order serial correlation which could result in spurious
inferences about the causes of national stock market co-movements, we
applied principal components analysis to the logarithms of the monthly
national stock market return relatives for the 1973-1987 period. The varimax
orthogonal rotation was used to obtain the final factor-pattern/structure
matrix. Using Kaiser’s significance rule, principal components with eigen
values greater than unity were retained. The factor loadings of the four
principal components which were found to be statistically significant are
presented in table 5. The factor loadings of the countries making the greatest
contribution to each principal component are shown in italics.
The first principal component is dominated by several central European
countries such as Germany, Austria, Switzerland, Netherlands, and Belgium,
which explains 40.1 percent of the total variation in international stock
market returns. The second principal component is dominated by Canada,
the United States, Norway, and the United Kingdom. The first two principal
components together explain about 49.4 percent of the total variation. Italy,
636 I. Merit and G. Merit, International portfolio diversification

Table 6
Principal components with international industry portfolio
indices (1973-1987)

Principal components
First Second
International principal principal
industry portfolios component component
Merchandising 0.852 0.254
Food & household products 0.837 0.366
Health & personal care 0.832 0.328
Insurance 0.745 0.444
Textiles & apparel 0.680 0.505
Energy 0.679 0.115
Building materials 0.665 0.589
Chemicals 0.648 0.604
Forest Products 0.644 0.487
Steel 0.097 0.861
Machinery 0.454 0.785
Electrical & electronics 0.503 0.705
Airlines 0.168 0.678
Automobiles 0.413 0.610
Banking 0.49 1 0.584
Non-ferrous metals 0.381 0.567
Appliances 0.445 OS47
Variance explained by
each principal component 60.7% 6.9%
Cumulative variance explained 60.7% 67.6%

Spain, and Japan are the major contributors to the third principal compo-
nent. This principal component explains only about 6.4 percent of the total
variation in international stock market returns. The fourth principal compo-
nent explains only about 6.3 percent of the total variation and is dominated
by Hong Kong and Singapore. Swedish stock market makes significant
contributions to the first two principal components and also some contribu-
tions to the last two principal components. French stock market appears to
make large contributions to all first three principal components. Australian
stock market appears to make large contributions to all last three principal
components.
Principal components analysis was also applied to the logarithms of the
monthly return relatives of the 17 international industry portfolios for the
1973-1987 period. Two principal components meeting Kaiser’s significance
rule are presented in table 6. The factor loadings of the industries making
greater contribution to each principal component are shown in italics. The
first principal component explains about 60.7 percent of the total variation in
international industry portfolio returns and it is dominated by merchandis-
ing, food & household products, health & personal care, insurance, textiles &
apparel, energy, building materials, chemicals, and forest products industries.
 I. Merit and G. Merit, International portfolio diversification 637

The remaining 8 industries make larger contributions to the second principal

component which explains only 6.9 percent of the total variation in
international industry portfolio returns.
A comparison of the country and industry principal components in tables
5 and 6 indicates that international industry portfolio returns are more
closely correlated than are national stock market returns. Therefore, there is
more to be gained from diversification across countries than across
industries.

4. The inter-temporal stability of international stock market co-movements

Box’s M statistical tests were used to study the inter-temporal stability of

the matrix of correlation coefficients among the 17 national stock market
indices. The 1973-1987 period was divided into ten 1.5-year, five 3-year, three
5-year, and two 7.5year sub-periods and the tests were applied to pairs of
consecutive sub-periods. We tested the hypothesis that the correlation matrix
of a given sub-period is the same as the correlation matrix of the preceding
sub-period. Table 7 reports the M-statistics obtained by comparing the
correlation matrices of the consecutive 1.5-year, 3-year, 5-year, and 7.5-year
time periods and the p-levels associated with these statistics. Our results
show that the correlation matrices of 7 out of the 9 pairs of consecutive 1.5-
year time periods and 2 out of the 4 pairs of consecutive 3-year time periods
are significantly different. However, for both pairs of the consecutive 5-year
time periods and for the two consecutive 7.5-year time periods, the hypothe-
sis that the correlation matrices are the same cannot be rejected. These
results indicate that the longer the time period, the greater the degree of
stability in international stock market relationships. Therefore, the longer the
time period, the better proxies ex post patterns of co-movement can be for
the ex ante co-movements of international stock markets.

5. Seasonality in international stock market relationships

We also applied Box’s M statistical tests to the correlation matrices of

consecutive months to determine if there is seasonality in international stock
market relationships. Since we have 15 observations for each month in the
1973-1987 period and since the number of variables must be less than the
number of observations to avoid singularity, we reduced the number of
countries in the sample to 14 by taking out Austria, Norway, and Spain from
the sample which have the three smallest stock markets in the sample. Table
8 reports the results of the seasonality tests. The hypothesis tested is that the
correlation matrices of pairs of consecutive calendar months are the same.
Our results indicate that, with the exception of the February-March pair,
the hypothesis that the correlation matrices of pairs of consecutive months
are the same cannot be rejected for the September-May period. However, we

JB.F- F
638 I. Merit and G. Merit, International portfolio diversijkation

Table 7
Box’s M statistics for the equality of correlation matrices

Box’s M
Sub-periods statistics P-level
_
I.5-year sub-periods
January 1973-June 1974 and July 1974December 1975 377.735 0.203
July 1974-December 1975 and January 1976-June 1977 468.083 0.003’
January 1976June 1977 and July 1977-December 1978 574.459 0.W
July 1977-December 1978 and January 1979-June 1980 505.931 0.W
January 1979-June 1980 and July 198GDecember 1981 446.547 0.010”
July 198GDecember 1981 and January 1982-June 1983 472.548 0.002”
January 1982-June 1983 and July 1983-December 1984 396.868 0.102
July 1983-December 1984 and January 1985-June 1986 441.753 0.012”
January 1985June 1986 and July 1986December 1987 505.557 O.ooo”

Average 0.037

3-year sub-periods
1973-1975 and 1976-1978 259.910 0.017”
19761978 and 1979-1981 247.924 0.047”
1979-1981and 1982-1984 243.053 0.068
1982-1984 and 1985-1987 225.601 0.207

0.085

J-year sub-periods
1973-1977 and 1978-1982 195.237 0.229
19781982 and 1983-1987 193.386 0.256

Average 0.243

7.5-year sub-periods
January 1973-June 1980 and July 198sDecember 1987 179.057 0.309
“Significant at 5 percent significance level.

found seasonality in international stock market relationships in the May-

September period. In this period, international stock market relationships
appear to have statistically significant changes from each month to the
following month.

6. Conclusions
In previous studies, the inter-temporal stability of individual correlation
coefficients between national stock markets has been analyzed. In this paper,
we analyze the inter-temporal stability of the matrix of correlation coeffi-
cients among international stock markets. We find evidence that, the longer
the time period considered, the better proxies ex post patterns of co-
movement can be for the ex ante co-movements of international stock
markets.
 I. Merit and G. Merit, International portfolio diverszjkation 639

Table 8
Box’s M statistics for the seasonality tests

Box’s M
Months statistics P-level
January-February 272.903 0.149
February-March 316.109 0.016”
March-April 291.411 0.063
April-May 269.443 0.172
May-June 297.359 0.046”
June-July 296.065 0.049”
July-August 334.097 0.005”
August-September 351.357 0.001”
September-October 276.077 0.130
October-November 257.828 0.267
November-December 264.051 0.213
December-January 166.733 0.771
“Significant at 5 percent significance level.

Although seasonality in individual national stock markets has been a

popular research topic in finance literature, seasonality in international stock
market relationships has not been investigated in previous studies. In this
paper, we find seasonality in international stock market relationships.
International stock market co-movements appear to be relatively stable in
the September-May period. However, the matrix of correlation coefficients
among national stock markets show statistically significant changes in the
May-September period.
In previous studies, the potential gains from international portfolio
diversification have been analyzed by studying the co-movements of interna-
tional stock markets. In this paper, we analyze the benefits of international
portfolio diversification by using both national and industry portfolios which
incorporate the same stocks. We find evidence that there is more to be
gained from diversification across countries than across industries. Diversifi-
cation across countries, even if within a single industry, results in greater risk
reduction than diversification across industries within countries.

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