Don’t short circuit the circuit breaker
The aim is to ‘chop off the bottom of the curve’; to stop the amplifying panic that is further assisted by unthinking computer-driven trading
Yet again events in the stock market have conspired to embarrass the Chinese authorities, once again proving that no matter how hard the visible hand of government tries, it is not possible to stay the invisible hand of the markets forever.
Why the volatile Chinese market had a price monitoring threshold or “circuit breaker” at just 7 per cent is a mystery that the regulators may be answering with their resignations. The Chinese market twice went 7 per cent “limit down” last week after which brokers were off games for the rest of the day. A speed bump at 5 per cent halted trading for 15 minutes but conveniently reminded investors that the full stop was not far away. Nervous traders saw the thresholds more as a target rather than a limit.
To stop trading for the rest of the day means that you are stuck in your positions until the next trading day. It prevented traders benefiting from the regular afternoon recovery. Topping this is the none-too-clever trading regulation that permits companies to suspend their shares if they think that prices might fall further. So everyone goes for the door at the same time to avoid being left holding the baby.
We are all aware that the red mist or the blue funk causes markets to overshoot and undershoot. Price movements can snowball into frenzy, or more often into a panic that pushes stocks down faster and lower than their valuations deserve. Stock market valuations serve as collateral for loans, determine company funding ability, and benchmark investor’s wealth, so the price discovery mechanism must at least provide valuations in the right ballpark – even during a crisis.
Left to its own devices, the Chinese market would probably have found its own level around 3,000 on the Shanghai Composite Index. It might even have sunk below the 2,927 that it reached in August last year – but by then it had already fallen by 44 per cent from 5,166 in June, so the selling frenzy was beginning to tire. However, the authorities rescued the market by buying through public agencies, known as the “National Team”, who pushed the market up to the artificially high 3,400 level. This excess valuation of 10 per cent to 15 per cent may not seem that much, but it was amplified in the psychology of market participants. It became a fall waiting to happen.
But let us not throw the baby out with the bathwater – circuit breakers are and have been very successful. They curb the irrational exuberance of markets to make impossible highs and suicidal lows. The aim is to “chop off the bottom of the curve”; to stop the amplifying panic that is further assisted by unthinking computer-driven trading. It adds a pause to allow investors to ponder logically and unemotionally for a moment and say maybe the selling has gone far enough. It allows sensible price discovery without damaging market liquidity.
Limits must be designed with an eye on the behavioural psychology of the participants. The US has assessed this better than most over the years, with measures to ease panic selling triggered at 7 per cent, 13 per cent and 20 per cent from the close. A decline at levels one and two before 3.25pm triggers a halt in trading for 15 minutes. After that time closing prices are allowed to reach equilibrium unhindered, although a fall of 20 per cent would halt trading for the day. Black Monday in October 1987 saw a plunge of 23 per cent so the circuit breakers are generous, measured and targeted – and not easily gamed by the market.
There are other measures to inhibit panic selling such as a US rule that allows out of hours trading should there be a crisis overseas. Other markets restrict short selling in part or whole, and both the US and Hong Kong have an uptick rule, where you can only short above the last traded price of the security. Many countries aside from China have bought their markets during a crash. Hong Kong made a large profit by selling the shares bought at crisis level back to the market through the Tracker Fund. Making money out a crisis is what a lender of last resort does.
Traders often complain about such rules being intrusive and restricting liquidity but they are designed to inhibit irrational, emotional moves when a market has lost its head, not rational price movement. In a crisis there is no liquidity anyway. Now is the time for Hong Kong to bring in a well-designed circuit breaker system. Forty years of personal observation tells me that such limits will inevitably be required.
Richard Harris is chief executive of Port Shelter Investment Management