Usually, when Wall St sneezes world share markets catch a cold.
But on February 26th, the Shanghai tiger snorted and fireballs went flying around the globe.
What caused the correction? Unfortunately, there is no simple answer.
After all, analysts are still arguing over the reasons for the crashes of 2000, 1987 and 1929.
Certainly, share market corrections are much easier to explain after they happen than predict.
For example, one audacious Australian electronic investor's guide claimed it had warned subscribers of the February correction but the so-called warning contained no mention of China.
What goes up must eventually come down. From May last year to February 26th this year, the major share markets had experienced very profitable - and smooth - times.
Indeed, Wall Street had experienced its longest period without a 2 per cent daily fall for more than five decades.
Closer to home, the ASX 200 rose by 19 per cent over 2006. This was the fourth consecutive year of positive returns and the third consecutive year in which the Australian index outperformed overseas share markets.
The result: after such good times, a 9 percent fall in one day on the Shanghai market triggered a good old-fashioned market forces correction around the major global markets.
Why did the China market take such a sharp dive?
After all, since their inception the Shanghai and Shenzhen markets have been through a number of roller-coaster like swings.
It was initiated by a statement by a senior politician that 70 per cent of Chinese domestically traded companies were worthless and should be delisted. "We must", he warned, "force bad children out."
This statement made the Chinese market dragon snort fire.
But it also had a very important silver lining. It was telling the world that the authorities had finally acknowledged that Chinese markets had problems which needed correction.
The two big questions now are whether they will act more rationally and with greater probity and whether the Chinese government will now impose tighter regulatory controls.
Why were other markets so vulnerable to the Chinese correction?
Good times on share markets temporarily blind investors to their inherent volatility. Indeed, the lower the volatility and better the market's performance the greater the risk taking.
Investors also forget that it is easier to take a position than to exit one.
Much more sophisticated investment techniques these days also exacerbated the sharpness of the falls.
For example, the rapid growth of hedge funds - which prefer to buy higher risk, higher yielding instruments and sell lower-risk, lower yielding ones to maximise their "carry", or income - means that when a correction begins the correction is greater than it would have been in a more old-fashioned market.
The greater use of what are called "value at risk models" by institutional investors also worsens volatility, as the models encourage asset sell-offs when markets turn south.
The inability of electronic trading systems to deal with dramatic market swings also contributed.
In New York, Dow Jones, which calculates the market average, found its systems unable to process orders quickly enough. It switched to a back up system but the delay then forced a bigger fall, as traders then adjusted their positions radically in response to the corrected market averages.
What are the main consequences of the February correction?
Two main ones are likely: greater volatility in the major equity markets and a slowdown in the upward trend in equity prices.
Was it a harbinger of a big crash to come?
Share market history shows that most fads, manias and bubbles start with something fundamental and, at some point along the way, they lose track of that fundamental. But the China correction was not a product of a change in any key global fundamentals.
True, the US economy looks likely to slow over the year ahead but not precipitously enough to cause a Wall St collapse.
Price equity ratios remain relatively low in most markets, interest rates are at near 30 year lows in many economies, earnings outlooks look reasonable and rapidly growing savings in the Western economies will continue to seek homes in equity markets.
Indeed, the Chinese correction provided a salutary reminder to market players around the globe that good times on markets are invariably followed by more sober times - something any investor ignores at their peril.
*Dr David Clark taught Business Economics at the University of NSW for 35 years, was an AFR and Personal Investor columnist for over a decade, and is now an investor educator. The views expressed in this article are Dr Clark's not necessarily Vanguard's.
