The sharp one-day drop in the Chinese stock market on Feb. 27 apparently had an enduring negative effect on major stock markets around the world. By the time the exchange closed that Tuesday, the Shanghai Composite Index had fallen 8.8 percent for the day -- the biggest one-day fall in China in 10 years.
A cascade of declines in other countries immediately followed. In Singapore, the Straits Times Index was down 2.3 percent when the market closed. In Mumbai, the Sensex 30 fell by 1.3 percent that day at the market's closing. In Moscow, the RTSI index was down by 3.3 percent at its closing bell. In London, the FTSE 100 was off by 2.3 percent when trading ended that day. In Sao Paolo, the Bovespa index was down by 6.6 percent and in New York the Dow Jones Industrial Average was down by 3.3 percent, when those markets closed.
These were significant declines -- larger one-day drops in the Dow, for example, have occurred only 35 times since January 1950, or about once every 20 months. Moreover, two weeks later, all these markets outside of China were down from 4.3 percent to 7.8 percent compared to their close on Feb. 26.
This large and enduring effect has surprised many, since the "story" about the Chinese drop -- that the trigger was a rumor that China's government, concerned about speculation, planned to impose controls on the stock market -- seems to have no logical relevance elsewhere.
But, unless one believes that stock markets move only in response to information about economic fundamentals, there really is no reason to be surprised. One-day drops in important stock markets have always had enduring and general effects, owing to market psychology. Given the international preoccupation with China's economic success, the country is now a highly salient market to investors all over the world.
If history is any guide, markets can be severely destabilized by one-day drops, which make powerful stories that have more psychological salience to investors than much larger drops that occur over longer time intervals.
For example, people were really agitated when the Dow dropped 3.8 percent on Dec.6, 1928, nearly a year before the famous 13.5 percent crash on Monday, Oct.29, 1929. Nowadays, of course, no one remembers that one-day slide in 1928, but, from the participants' perspective, it was an enormous event. Newspapers the next day described it as "one of the severest declines the market has ever gone through," and "the worst money scare since July 1, 1920."
No news story that day discussed economic fundamentals or gave a clear indication of the cause of the decline, relying instead on sensational prose -- "the house that Jack built threatened to topple over" and "traders were quaking in their boots." But the Dec. 6, 1928, event began a sequence of increasingly severe one-day drops in the Dow over the course of the following year. Despite a generally rising market, the Dow fell by 3.6 percent on Feb. 7, 1929, 4.1 percent on March 25, 4.2 percent on May 22, 4 percent on May 27 and Aug. 9, 4.2 percent on Oct. 3 and 6.3 percent on Oct. 23, before the infamous "Black Monday" crash.
On each occasion, newspaper accounts further established the 1929 market psychology. The story was always that speculation in the markets had government leaders worried, which is, of course, essentially the same story that we heard from China on Feb. 27.
The historical parallels do not stop there. On Sept. 11, 1986, the Dow dropped 4.6 percent, the steepest one-day decline since May 28, 1962. This was followed the next day by a further 1.9 percent decline, and then, over succeeding months, by a series of sharp one-day drops that were precursors to the 22.6 percent collapse on Oct. 19, 1987 -- the largest-ever one-day correction.
At the time of the Sept. 11-12, 1986, event, I thought very hard about what could have caused it. Media accounts were vague, with the respectable story pointing to the "rekindling of inflation fears," which, in fact, was not news. I wondered what people were really thinking, apart from what could be read in the newspapers.
Immediately afterward, I sent out a short questionnaire to 175 institutional investors and 125 individual investors in the US. I asked, "Can you remember any reason to buy or sell that you thought about on those days? [Please try hard to remember. Don't cite something you thought or talked about later]." The response rate was 38 percent, and no reason was repeated by more than three respondents, except the stock-market drop itself.
This, and a more elaborate questionnaire that I sent out after the next "Black Monday" crash on Oct. 19, 1987, convinced me that nothing more sensible is occurring than just what newspapers describe: speculators, responding to changing market prices, and fearing further changes in the same direction, simply decide to bail out. The actual decision to do so often can wait until the next stimulus, that is, the next day that a big drop occurs -- hence, the possibility of a sequence of large one-day declines.
Unfortunately, this behavioral theory of stock market movements is not amenable to easy quantification and forecasting. After Feb. 27, it looked as if the markets were settling down, and the VIX measure of stock market volatility had fallen back nearly to earlier levels. But then a 2 percent fall in the Dow on March 13 pushed the VIX back up.
The bright side is that one-day stock market declines occur more commonly as isolated events with no long-term repercussions. So investors must now hope that the latest episode will be forgotten -- unless and until hope succumbs to market psychology.
Robert Shiller is a professor of economics at Yale University and chief economist at MacroMarkets LLC, which he co-founded.
Copyright: Project Syndicate
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