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Stock Market Circuit Breaker

Sigma Investment Counselors

January 15, 2016

As a Chinese native and resident for most of my life, I have been watching the equity markets there with great interest these past several days.  I am hopeful that my friends and family there are conducting their affairs with a clear mind.

The Chinese stock market circuit breaker rule was implemented on January 4th this year.   The rule was that a 5% rise or fall on the major Chinese indexes would trigger a 15-minutes trading halt.  A move of 7% at any time would stop trading for the rest of the day.  On January 7th, the Chinese stock market took a deep nosedive and the losses reached 7% right after the market opening and triggered a complete suspension for the rest of the day.  The trading session lasted only 30 minutes.  Later that evening, Beijing announced the suspension of this circuit breaker rule.

In many other major stock markets, including the U.S., a circuit breaker was designed to avoid panic in the stock market by putting in temporary halts or a freeze in trading.  It is meant to provide a timeout, giving investors a chance to calm down.  But instead of having a calming effect, the trading suspension made Chinese investors panic.  Why?

There is one technical explanation.  China’s trading halts were triggered too easily for such a volatile market.  It is not uncommon for the volatile Chinese stock market to experience a 5% up or down move in a normal trading day.  A 15-minute pause after 5% drop gives investors time to assemble their sell orders.   And then, when the market drops 7% and is shut for the day, investors do not have access to buy shares if they believe the market is at a bottom.  The market suspension builds up a panic mentality, drains the market liquidity, and creates a stampede.  A similar circuit breaker exists in the U.S., but with much wider gaps: It temporarily halts trading after a 7% drop in the S & P 500 Index, then again at 13%—but suspends trading for the day only if losses reach 20%. 

The circuit breaker is another example of Chinese regulators failing to acknowledge that there are always unforeseen consequences when government tries to intervene in markets.

All comments and suggestions are welcome.

Wenma Gorman, CFA®

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