How China's Stock Market Affects US Indexes

Between plummeting oil prices, a Shanghai stock market that had to be shut down twice in as many days, and the worst start of a year in history for the S&P 500, it's been -- to put it mildly -- a bit of a January. China has taken center stage as regulators attempt to intervene in a market that seems determined to fall, a situation that has investors in American investors just as worried.

If you're wondering how it all fits together, you're not alone. Why does the Shanghai index matter to the S&P?

Mixing up the stock market

You might be surprised to find that, technically speaking, the Shanghai index and S&P 500 have very little in common historically. A study looking at the last two years of returns found that the correlation between the indexes (measured by a number called the correlation coefficient) was just 0.15. For the correlation coefficient, 1.0 describes two markets that move completely in lockstep and zero means that the markets have no influence on each other at all. That means 0.15 is quite low indeed. 

Of course, that could be a fluke based on too little data. But going back 10 years shows a correlation of 0.37 between the S&P 500 and the Shanghai index. 

Part of the reason behind Shanghai's apparent independence is that market in China plays by its own rules. Regulators at the Bank of China have undertaken significant measures to get a handle on recent stock market volatility. Their actions include trading suspensions, stopping initial public offerings, using government agencies to buy up index funds, limiting short sales, and even banning large individual shareholders from selling.

This kind of interference in the market is unheard of in the US, and it throws a wrench into an already-complicated valuation process. There is always concern that data coming out of Chinese economic authorities and companies is not completely transparent. Added to outright market interference, investors begin to lose confidence in the Chinese market as a whole.

For an indication of how bad this can get, prominent hedge fund Nevsky Capital, which returned 6,400 percent in the past two decades, recently closed its doors. One of the key reasons? In a letter to investors, the founder said that a lack of transparency in markets like China is making it increasingly difficult to make good investments.

While it's just one (admittedly somewhat extreme) example, Nevsky's closure exemplifies the unintended consequences of Chinese market interference. Taken in tandem with a faltering Chinese economy, investors can't help but worry.

Economic worries pave the way for market concerns

Economic growth is a big issue for China. While its growth rate of 6.9 percent in 2015 is enviable by American or European standards, it's the lowest the country has seen in 25 years.

When China grows, many would argue, the rest of the world also grows. But when it slows, well, everyone start to worry. That worry is justified: by World Bank estimates, a 1 percent decline in China's growth rate causes a 0.5 percent drop in global growth.

So, even though China is still far from a recession, it's still at risk -- and given concerns about how realistic these growth numbers are, it's difficult for investors to gauge just how much risk there is. Chinese policymakers' usual methods for steering the economy also appear to be losing effectiveness. This is becoming more worrisome due to China's ballooning debt levels, which will further limit the government's ability to maneuver.

So what does all of this have to do with the US markets?

While the Chinese stock market may not move in line with the S&P 500 historically, the Chinese economy certainly affects American companies. The volatility in the Shanghai stock exchange and the somewhat panicked and ineffective response could be acting as an indicator of how well-managed (or not) the Chinese economy is as a whole.

With policymakers struggling to keep a lid on a volatile stock market, it's not a stretch to imagine that they could be in for a whole new level of pain if and when the economy starts to really struggle.

Again, a lack of faith in the data is part of the problem on both fronts. Investors make decisions based on the state of world today and where it's expected to go tomorrow; when the state is uncertain, it's even more difficult to estimate where economic trends might go and how they might affect American companies.

Either way, recent events have analysts worried. Whether those fears will play out as badly as the first few weeks of the year imply is left to be seen; however, correlation coefficients notwithstanding, there are a number of people stateside who are paying close attention to the market drama in Shanghai.

What can I do?

At the end of the day, as an investor you might be watching all of this and wondering how on earth to manage. Do you go the way of Nevsky Capital and get out of this investing business altogether?

Chinese policy aside, markets go up and markets go down, as the old saying goes, and it's impossible to know exactly where they'll go next. It's important to remember that part of the short-term volatility is driven by emotion rather than analysis, and these short term movements can and do often overshoot the mark of reality.

In other words, rather than getting bogged down in the day-to-day volatility of a changing situation, it's better to sit back and take the long view. Review your investing strategy and your target allocations and stick with the program and keep your discipline. Down markets are often a good time to buy, but timing the market is often a surefire way to lose your shirt.

Instead, keep it very boring by adhering to the investing schedule you have planned and try to take a wider-lens view of the market's gyrations -- one that doesn't count the weeks and months, but rather the years and decades.