China Stock Market Crash Jan 2016 Explained: Why, What, How, Future

jan 2016 china stock market crash explainedIs China on the Verge of a Major Stock Market Crash?

Christmas lights were barely back in the boxes when we saw the first China stock market crash of 2016. The Chinese market crash on January 4 triggered an automatic suspension of trading activity, making it a depressing start to the New Year.

We essentially began 2016 with a sliding stock market and not a miniscule one either. This wasn’t a case of three or four percent, it was a one-day seven-percent crash that sent ripples through other stock exchanges around the world. (Source: “China stocks rout on first market day of 2016 trips national trading halt,” Reuters, January 4, 2015.)

Moreover, this could be the start of a stock market crash to mirror the one we saw last summer. The Chinese market was in freefall during those months, losing more than 30% of its value during a handful of weeks. It was a bloodbath.

As a result, China took steps to limit fear in the market. They created an automatic circuit breaker to halt trading if the Chinese market fell by five percent. Investors would get 15 minutes to calm down a little bit before trading resumed and if the losses still extended to seven percent, markets would be temporarily closed.

The circuit breaker was implemented on January 4, 2016. That’s also the first day it was used. Here’s what happened.

Why Did It Happen?

Investors are capable of extraordinary self-delusion. One of the things I’ve learned about markets is how primal instincts like fear and greed dominate the big swings. Rational calculations may eventually win the day, but the tipping points are all sentiment.

Legitimate reasons for a sell-off can be ignored for months. Slowing growth, anemic exports, and excessive credit are just a few examples. These factors continue to bubble underneath the surface regardless of what investors tell themselves. Eventually, enough bearish reports can shatter the optimism, leading to widespread panic.

That’s what happened here. The implementation of the circuit breaker was the tipping point. Sure, there’s been weak economic data coming out of the Middle Kingdom, but we didn’t see this large of a sell-off last week or the week before.

Investors were more than willing to ignore the previous China stock market crash if they could get a bull market in the bargain. We saw a resurgence of initial public offerings (IPOs) in November, indicating that Chinese investors had regained an appetite for new equities.

There was also a six-month mandatory holding period for institutional investors. Since they tend to own big chunks of stock, the Chinese government banned them from selling shares during the height of the crisis. In order to pacify markets, that ban had to be of significant length. However, it’s set to expire soon, which investors find unsettling.

See what I mean about emotion?

Is the Chinese Market Crash Over?

When Chinese investors hold shares in a company, they should technically value the stock on changes in the underlying business. But they don’t. They’re terrified its value could collapse once institutional investors are allowed to liquidate their shares, so they lace up their shoes and wait by the exit.

At the first signs of a sell-off, investors trip over each other to get out. The Chinese market crashed five percent and the circuit breaker instigated a 15-minute halt in trading. Rather than use that time to moderate their reaction, investors got even more scared.

When trading came back online, it took only seven minutes for the losses to break below seven percent. Mob mentality plays a bigger role in our investment decisions than anyone likes to admit. (Source: “China’s Seven-Minute Selling Frenzy That Shook Global Markets,” Bloomberg, January 4, 2015.)

If institutional investors CAN sell, it means they WILL sell, right? And if the smart money is leaving, I should sell, too…right? There’s no way all these smart people are wrong.

This is what fear-based thinking looks like and it’s also why the China stock market crashed.

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