Chinese Stock Market — Full Meltdown Approaching?
Last updated on January 1st, 2017 at 07:07 pm
Last night, China’s principal benchmark, the Shanghai Composite index, collapsed 7.4%. Ouch! Now that’s what we call a drawdown!
Hundreds of stocks hit their daily 10% drawdown limit (where selling is not allowed below the limit price for the rest of the day). Chinese market news is exploding across the internet and we’re seeing panicky keywords like “freakout,” “nosedive,” etc.
So how bad was it?
In order to evaluate this question, we ran a quick analysis based on the historical daily returns for the Shanghai Composite index. Between 12/20/1990 and 06/26/2015, the historical probability of losing more than 7% on a day is 0.72%! So was it pretty bad? Yes it certainly was, at least compared to fairly recent history.
Next we looked at the S&P 500 daily return between 07/03/1962 to 06/26/2015. Note that this sample covers a significantly longer time frame. What if we saw a similar drawdown for the S&P 500? The historical probability of losing more than 7% in a day for the S&P 500 over this period is only 0.04%! A very rare event indeed.
Clearly, the carnage we observed yesterday in the Chinese markets would have even fewer precedents when viewed through the lens of US markets.
So this is a rare event by almost any standard, yet we are seeing this outcome in China today. So how concerned should we be?
One of the reasons that the market blow up we are seeing in China is so terrifying, is that 1) the market has already surged a lot (the Shanghai Composite had surged ~40% year to date, prior to last night’s pullback), and 2) a key driver behind the rally was the use of leverage. As the Shanghai rallied earlier this year, many individual investors had increasingly used leverage to finance additional purchases of securities.
So what can a 7.4% daily drawdown do to a leveraged portfolio? Assuming you have $1 million, and you use 6X leverage (which is in line with some leverage ratios we are seeing for Chinese individuals), your gross market exposure is $6 million. When you hit a 7.4% drawdown, you will lose $444K — basically half of your initial $1 million capital is gone. Poof! According to some reports, there are investors with upwards of 10X leverage. For those investors, that story will certainly not have a happy ending.
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