Did Markets Overreact to China?

My latest Risk.net article, co-authored by the fabulous Kathe Macleod, director of Risk at  Senator Investment Group. My column is now fully branded under the “Riskology” moniker.


Results of different models for US equity response to Chinese drawdown. Click to enlarge. The analysis is in the text.

As international markets gyrated over the past several months it seemed to us that participants possibly adopted a “hair-trigger” or reactionary approach and thereby exaggerated both the impact and contagion of what would otherwise have been localized market events. Specifically, we wanted to examine if markets overreact to single-factor events by evaluating if stocks are oversold relative to single-factor exposure. China’s dramatic and unprecedented June and August sell-offs are good candidates for such a study. As we discuss here, for a variety of reasons we found June more representative of single-factor events than the August sell-off and therefore limit our analysis to the June sell-off.

Beginning with the peak on June 12, the Shanghai index did not reach its local trough for 26 days, for an accumulated 32% drop in the SHCOMP (Shanghai) index. This registered as a -3.6 sigma event given its then recent 180-day historical volatility. We examined the returns of the constituent stocks of the US S&P 500 index during the same period by constructing a model that takes into account each stock’s direct exposure to Chinese markets by incorporating that company’s fraction of revenue from China. We consider this a natural way to construct such a model and expect that this is a common approach to analyzing similar situations.

You can download the full article from the IA website.

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