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Exactly What Has Happened in China's Stock Market

Friday, January 8, 2016 6:01

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It’s a picture-perfect example of the law of unintended consequences…

The Chinese government expected one outcome… and got a wholly different one.

Chinese stocks crashed dramatically last summer. So a few days ago, the Chinese government introduced a measure to prevent a repeat of that in 2016.

Specifically, it introduced stock market “circuit breakers.” It expected that these would give investors a feeling of safety and security – that the market couldn’t fall too much in a day.

The outcome was the opposite… Fear, volatility, and panic are ruling China’s markets – significantly due to these government-created circuit breakers.

Why has this measure failed so badly? I will explain below. It comes down to the law of unintended consequences.

Governments have been making mistakes based on this for centuries. Two centuries ago, economist Frédéric Bastiat explained it perfectly:

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen, and those effects that must be foreseen.

Here’s what happened in China:

Chinese stocks are extremely volatile – much more volatile than U.S. stocks, for example.

So the Chinese government wanted to introduce a way to have the markets not be so volatile.

It came up with a specific plan that went into effect January 4. If the stock market falls by 5% during a day, it will close for 15 minutes. After the market reopens, if it then falls to a total loss of 7% for the day, it will close for good for the day.

Instead of reducing volatility, these “circuit breakers” have dramatically increased it…

Here’s how it goes… As stocks start to fall in China, investors quickly start bailing out, so they can get out ahead of the 5% circuit breaker. Then, once the 5% threshold is hit, panic sets in and lots of sell orders hit to get out before the market is shut down for the day at the 7% level.

It’s not that circuit breakers like these are a bad idea… Most markets have them.

In the U.S., trading is halted for the day if the stock market falls by 20% in a day. (Before we hit the actual shutdown point, trading is halted for 15 minutes if the main stock index falls by 7% and then again by 13%.)

The problem in China is, the thresholds (5% and 7%) are just too darn tight.

After two horrible trading days in Chinese stocks – the market was open for less than 30 minutes on Thursday before shutting down – the Chinese government decided to “suspend” its circuit-breaker system (for now).

Hey, at least the government moved decisively to stop the bleeding.

If you have followed my writing, you know that I believe Chinese stocks have incredible upside potential over the next five to seven years…

However, lately Chinese stocks have been in a downtrend. We have stopped out of some of our China trades since the selloff began.

This is fine. It is the way it will be… We will take a few losses on the way to what could potentially be hundreds-of-percent profits.

I expect the Chinese authorities will get this sorted out. Then, the next thing will come up, and they will get that sorted out as well. This is all “growing pains” on the way to becoming a legitimate financial superpower.

Me? I am following my stops and cutting my losses in some China trades.

When the uptrend returns, I will be back… I don’t know when that day will be. But I do know that China is a long-term story that I want to be a part of…

Good investing,

Steve

Source: http://www.stansberryresearch.com/dailywealth/3176/exactly-what-has-happened-in-china-s-stock-market

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