Chinese stocks crashed 8.5% on Monday, July 27, 2015, but the headline loss doesn’t even begin to describe it. More than two-thirds of the stocks on Shanghai Composite hit the 10% floor and trading in those was stopped. The Chinese stock market is now down 28% from its peak in June.  That raises the following questions, the answers to which you may want to share with your clients.

1: What is driving these extreme losses?

2: Is the worst over for China?

3: What could be the impact in the U.S.?

Pundits on CNN suggest that a drop of 0.3% in China corporate profits is responsible for this bloodbath. A mere 0.3% drop.

It seems incredible that such a small drop caused tremendous market stress when we’ve seen similar or bigger drops in China corporate profits in 2014 and earlier this year (as large as 7%). It should be no secret to anyone that a global economy is slowing down, so why would a mere 0.3% drop cause such panic? The drop in corporate profits was just a trigger. As a Reuters story summarized how China watchers responded: “Analysts struggled to explain the severity of the sell-off, which accelerated sharply in the afternoon session, long after investors had time to digest the latest economic releases.”

So is this the famed Black Swan, something that nobody could ever predict? Far from it. All of these crashes have their own logic that is remarkably similar. Here is how you can explain it to your clients. Events like the 8.5% daily drop are not rational responses to economic news; they are due to the feedback loop of losses on the over-levered market. It works like this: prices drop for whatever reason and then the feedback loop ensures:

Lower prices lead to margin calls which forces selling to meet those margin calls which in turn causes prices to fall even more.

Back in 2002 RiXtrema’s senior scientific advisor, John Danielsson, came up with an ingenious way to illustrate this vicious cycle using a London Millennium Bridge analogy (and he did so long before the topic of margin debt became a big news story).

Millennium Bridge was opened in 2000 with much fanfare, but when people tried to walk on it the bridge began to sway violently. To visualize this effect, see this video of people trying to cross the bridge. What engineers found was that the original wobble defect of the bridge was very small, hardly detectable. But what made the bridge sway violently is many people adjusting simultaneously and in rhythm to the wobble, thereby causing an ever bigger wobble. The small original wobble in our case is the 0.3% drop in Chinese corporate profits. The rest is margin lenders and traders adjusting simultaneously.

The Drivers: Leverage Both Visible and Invisible

So how did all this work to cause the July 27 panic? It is no secret that China has had for years a massive real estate bubble. That bubble was gradually deflating since 2011 when the Chinese government started increasing interest rates and banks started limiting real estate lending. However, events around the globe and a local slowdown forced Chinese authorities to start reducing interest rates to increase the supply of money.

Some of this easy money found its way into the stock market to increase leverage. The simplest form of this is legal margin debt on stock exchanges. In March 2015 the combined margin debt on Shanghai and Shenzhen stock exchanges hit 1 trillion yuan for the first time ever, and by June 2015 it was already over 2 trillion yuan. Rather than a Black Swan, this parabolic growth in debt was quite visible. In principle, this is not much different than any stock financial crash in history, not excluding the 2008 Lehman collapse.

But legal margin debt is rarely enough for the kind of panic we are seeing. In the case of the 2008 crash there were many other sources of shadow leverage, from off-balance-sheet vehicles created by investment banks to hedge fund financing. In today’s China, this hidden leverage has reached staggering proportions. According to estimates from Bank of America Merrill Lynch the true size of the margin funds used in the stock markets is closer to 4 trillion yuan even as legal margin debt has decreased to 1.4 trillion yuan (for more on China’s margin issues, see this post).

Is the Worst Over?

Likely not, as the amount of shadow leverage still present in the system is very high. It is possible that China’s centralk bank–the People’s Bank of China, or PBC–will go all out in its support of the markets further reducing rates and buying up assets and markets will respond.

So we are not saying that panic losses will necessarily continue right away. But until leverage is reduced, Chinese equities will not be a safe place and days like July 27th will be seen again.

What Will Be the Impact in the U.S.?

It is not likely that there will be an immediate impact on the U.S. American stock markets also have significant amount of leverage, but the mechanism for pumping this leverage in is completely different from previous crashes. Most of the money flows into the stock market via borrowing by corporations who then buy back their own stock. This topic warrants a whole separate post, which is forthcoming. But the point is that until corporate bankruptcies rise, it is unlikely that the effect on the U.S. stock market will be dramatic.

When there is international contagion it happens because levered traders get burned in one place (China) and have to liquidate parts of their portfolio elsewhere (U.S.). In this case the leverage is mostly contained within China and held by Chinese traders, so the threat to the U.S. financial system is mostly contained.

However, due to the way U.S. stock market leverage is financed, there is danger in corporate credit, particularly in high-yield funds. Make sure that your clients understand that high-yield funds are really not like any other fixed income instrument and carry equity-like risks (or even worse at this point).

U.S. Treasuries are still an important asset and should be held for their diversification benefits which become even stronger in crisis events. By the way, when volatility hits, this will hurt investors at many robo-advisors, since their models typically lead them to underweight Treasuries, as I explained in a previous Journal of Financial Planning blog.

Summing Up

So what we are arguing, and what you may want to share with your clients, is that:

-          A China corporate profits drop of 0.3% cannot be responsible for the bloodbath in Chinese equities

-          China’s stock market trouble is not over: Leverage in the Chinese equity markets is huge, upwards of 4 trillion yuan, with most of it hidden from the authorities’ view and thus very difficult to deal with

-          Potential for contagion to the U.S. is limited, because Chinese traders with excess leverage do not hold appreciable amounts of U.S. assets

-          While the U.S. stock market is also over-levered, the leverage comes from corporate borrowing and stock buybacks

-          High-yield funds carry especially high risks right now

-          U.S. Treasuries are still an important part of the portfolio

-          The first wave of robo-advisors have algorithms which tend to underweight Treasuries, which will be a source of pain when volatility hits