The Magnet Effect

January 18, 2016

 Already the world’s stock markets have started 2016 with a major disappointment. At the center of the sell-off is the Chinese stock market and renewed fears over its slowing economy. While the data has been largely mixed, some of the chaos can be attributed to poorly designed safety mechanisms in the structure of China's stock exchange which potentially started a chain reaction of fear selling that eventually spread across the world.

 

In an effort to modernize their economy, the Chinese government has been trying to shift their economic focus to their own citizens and away from exports. Part of this shift has been trying to encourage more domestic participation in their own stock market. One of the ways they thought would create more confidence in what has historically been an incredibly volatile market was to institute safety controls that would slow down sell-offs and even halt trading when the market reached certain levels. However, these controls ended up having the exact opposite effect and compromised the confidence of Chinese investors.

 

The first safety measure was to halt trading after a 5% drop in the stock market for fifteen minutes in order for investors to calm down. The hope was with a small break, investors could regain emotional control and act rationally. Once trading resumed there was another halt 2% below that which would stop trading for the rest of the day. However, by freezing the market, this created a panic and a rush for the exits instead. After the market halted for 15 minutes, it created even more fear that the market could be shut down and investors lined up to begin selling the moment trading started again. This phenomenon is being called the "Magnet Effect" because the breaks are actually pulling the markets downwards. On the worst day, the market was only tradeable for 14 minutes before trading was stopped for the day.

 

The Chinese have since abandoned the safety measure, but the damage was already done. Confidence is incredibly important for a modern economy to work efficiently and once that has been broken, it takes time for it to heal. While the resulting volatility is unfortunate for investors in the short-term, emotional markets can often create pockets of opportunity for the disciplined investor.

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