Does Europe Really Affect the Dow?

When it comes to early-morning market predictions, U.S. investors often turn to overseas markets as a guide for how U.S. stocks will fare. For instance, this morning, European markets were mixed as of 7:30 a.m. EDT, with the FTSE 100 (FTSEINDICES: ^FTSE  ) up slightly following a report that U.K. GDP increased a minor 0.3% last quarter, while the German DAX (DAXINDICES: ^DAX  ) was flat despite declining unemployment in Germany. That, in turn, led to a rise of about 0.3% in U.S. market futures.

But even though national economic prospects are increasingly linked by the growing global nature of the world economy, you can't always count on European stocks to tell the whole story of what will happen with the Dow Jones Industrials (DJINDICES: ^DJI  ) when trading begins every morning in New York.

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When correlations break down
Under ordinary circumstances, stock markets around the world tend to trade in fairly similar directions. Investors definitely saw that phenomenon play out during the financial crisis, when no major stock market provided refuge from the massive declines that resulted from threats to the entire global financial system.

But the premise for high correlations across stock markets is that the fundamental economic conditions affecting countries throughout the world are similar. Lately, though, that premise hasn't held true, as the European economy has faced unique challenges that reflect regional political considerations as much as global economic effects. Problems in smaller eurozone nations like Greece have spread to more economically important countries such as Italy and Spain, and relatively healthy nations like France and even Germany are feeling the impacts of European sluggishness.

In part because of the recessionary conditions in Europe, European stock markets have seen their correlations with the rest of the world fall to their lowest levels in five years -- all the way back to the fall of Lehman Brothers, which some investors identify as the true beginning of the financial crisis. With little sign of a quick recovery for Europe, prospects in the U.S. look favorable enough that the stock market has drawn attention not only from domestic investors but also from investors outside the U.S.

Can the U.S. go its own way?
The other reason to question Europe's influence on the Dow has to do with the overlapping hours during which markets on both sides of the Atlantic are open. Quite often, economic news in the U.S. that gets released before the U.S. stock market opens has an influence not only on U.S. stock futures, but on active European markets. By the time trading begins in New York, Europe has already reflected the news in share prices, but to the casual observer, it can appear that Europe led the Dow lower. In reality, though, news that would have primarily influenced the Dow got a head-start with European markets, producing a misleading implication about causality.

If anything, the biggest influence Europe has on the Dow is at the individual-company level. For instance, last year, Coca-Cola (NYSE: KO  ) got only 10% of its revenue from Europe, but the segment provided well over a quarter of its pre-tax profit. Margins in Europe were similar to the high levels Coke enjoyed in Latin America and far above the core North American market. Johnson & Johnson (NYSE: JNJ  ) got a quarter of its sales from Europe, maintaining a substantial asset base on the Continent as well. The company hasn't seen the growth it would like in the region, but J&J's revenue from Europe has avoided the big declines that its U.S. business has seen.

Put Europe in perspective
Ignoring European stock markets entirely is clearly a mistake, as much of what happens in Europe has an impact on the U.S. as well. But giving too much credit to Europe for driving U.S. stocks is also a mistake. Despite the rise of emerging markets, the U.S. is still the largest economy in the world, and its influence makes investors around the world take notice of conditions here.

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