Just as "bad cases make bad law," to cite the ancient legal adage, bad stock markets make for bad investment decisions. China's stock market, with its repeated crashes, has the entire world in a tizzy.
The Shanghai stock exchange experienced its shortest trading day ever on Wednesday, as circuit breakers designed to end trading if the market slid 7% kicked in after only 14 minutes of active trading. As my colleague Julie Makinen reported, the Shanghai Composite has dropped about 12% this year, and the Shenzhen composite has fallen more than 15%.
Investors in the U.S. have taken the opportunity to sell. As of Thursday's close, the Standard & Poor's 500 index is down 4.67% from the opening bell for 2016 trading Monday, the Nasdaq has lost 4.29%, and the Dow Jones Industrials have shed 5.12%. European stocks have marched over the cliff in tandem.
The world should take a deep breath. The China stock market meets the definition of a bad stock market.
The market is the target of relentless intervention by the Chinese government, which has been setting investment rules and tweaking them without any evident understanding of how open markets work. Adding to the chaos, the market was inflated by an inflow of small investors buying on huge margins — a notoriously skittish class of investors buying under conditions that made them especially vulnerable to the market's volatile swings.
Last April, as Evan Osnos of the New Yorker reported, the official organ of the Chinese Communist Party exhorted citizens to plunge into the market. An upsurge of more than 80% in four months was "merely the start of a bull market." Investors should take heart from the government's determination to keep Chinese companies strong.
"Over the next two and a half months, investors opened thirty-eight million new stock accounts, more than quadruple the number of accounts opened in all of 2014," Osnos wrote. "Retail exchanges, equipped with audience seating, attracted retirees and other small-time investors who spent hours scanning the digital displays, like visitors to the dog track."
This was a bubble primed for pricking. But that wasn't all. On July 8, during a major market crash, Chinese regulators imposed a lockup on shareholders owning 5% or more of their companies, prohibiting them from selling for six months.
The effect of lockups is well understood in mature stock markets; they tend to create latent bearish pressures as the expiration approaches. That expiration was due for Friday, Jan. 8, plainly creating some of the downdraft witnessed this week.
The circuit breakers are another source of trouble. Introduced Jan. 4, the rules halt trading for 15 minutes after a 5% drop in the benchmark CSI 300 index, and stop trading for the rest of the day when the index falls 7%. They were triggered on day one, and again on Wednesday.
Circuit breakers exist in U.S. markets, but critics say they're cinched too tight in China, where 5% swings have been far more common. In the U.S., trading is shut down only if the Standard & Poor's 500 benchmark falls 20% in a day.
Adding to the confusion is that Chinese authorities lack the courage of their own convictions. On Wednesday, regulators tried to keep the bear caged by extending the stock lockup for three more months, albeit in modified form--big shareholders could sell, but only up to 1% of their companies' shares. And following the circuit-breaker meltdowns of Monday and Wednesday, they scrapped the circuit-breakers themselves, a clear indication that they were not implemented properly in the first place.
Among other signs of the immaturity of the markets and their regulators are stiff limits on short-selling--after a market crash this summer, the Shanghai and Shenzhen exchanges banned one-day short sales, in which traders place short orders and cover them on the same day. Mature exchanges understand that short selling is an indispensable relief valve for overheated bull markets.
All these features, artifacts of the government's inclination toward intervention in the stock market on the bull side, make the market an unreliable gauge of economic trends, many critics say. (Though they're not unanimous — last February, economists at MIT and New York University argued that the market had matured to the point that it was providing reasonably accurate signals about future corporate earnings. "China’s stock market no longer deserves its reputation as a casino," they wrote.)
None of this means that there's not cause to be concerned about the Chinese economy and its effect on world markets. Underlying the Chinese market plunge are signs that the world's second-largest economy is slowing down, and that government economic officials aren't fully up to the task of managing it.
They've been frantically depreciating the Chinese yuan, which will put pressure on the nation's trading partners by making Chinese exports more competitive and imports more expensive. The rapid depreciation sends a signal, moreover, that policymakers are getting to the end of their stimulative arsenal.
Adding to uneasiness about government policy, no one has ever been entirely certain about the pace of China's economic growth because its official figures are untrustworthy. Gross domestic product may have been overstated as much as three-fold, some observers believe.
There's no question that cracks in the Chinese economy are worrisome, but the wild swings of the stock market may be exaggerating the mood of panic. It makes sense for investors worldwide to keep their eye on the economy, but the stock exchanges? Just watch the ride.