Macroscope | 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.
Limits must be designed with an eye on the behavioural psychology of the participants
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.