Predicting Chinese Stock Market Crashes

Sebastien Lleo

NEOMA Business School

William T. Ziemba

University of British Columbia (UBC) – Sauder School of Business

December 1, 2015


Predicting stock market crashes has been a focus of interest for both researchers and practitioners. Over the years, several prediction models have been developed, mostly for use on mature financial markets. In this paper, we investigate whether traditional crash predictors, the price-to-earnings ratio and the Bond-Stock Earnings Yield Differential model, work for the Shanghai Stock Exchange Composite Index.

Predicting Chinese Stock Market Crashes – Introduction

Through the summer of 2015, the gyrations of the Shanghai stock exchange captured the headlines of the financial press. In fact, what has been labeled the “2015 Chinese stock market crash” is just the latest in a series of eighteen major downturns in the twenty-five years of the Chinese stock market history. Headlines aside, the Chinese stock market is certainly one of the most interesting equity markets in the world by its size, scope, structure and recency. These features have a deep influence on the behavior and returns of the Chinese stock market.

First, we discuss four key stylized facts on the return distribution of the Shanghai Stock Exchange Composite Index (SHCOMP). Then, we explain how equity downturn and crash prediction models work, and how to test their accuracy. The construction process for the signal and hit sequence is crucial to ensure that the crash prediction models produce out of sample predictions free from look-ahead bias. It also eliminates data snooping by setting the parameters ex ante, with no possibilities of changing them during the analysis. More importantly, the construction process removes the effect of autocorrelation, making it possible to test the accuracy of the measures using standard statistical techniques. We also conduct a Monte Carlo study to address small sample bias.

In this paper, we test whether the price-to-earnings ratio (P/E) based on current earnings, the Bond-Stocks Earnings Yield Differential model (BSEYD) and the Cyclically Adjusted Price-to-Earnings ratio (CAPE), accurately predicts the downturns of the SHCOMP. We find that the logarithm of the P/E has successfully predicted crashes over the entire length of the study (1990-2015). On a shorter 9-year period (2006-2015), we find mixed evidence of the predictive ability of the BSEYD models and CAPE. Overall, this study provides supporting evidence for the application of crash prediction models to the Chinese market.

A Brief Overview of the Chinese Stock Market

Mainland China has two stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange. The Shanghai Stock Exchange is the larger of the two. It is also the fifth largest stock market in the world by market capitalization. The modern Shanghai Stock Exchange officially came into being on November 26, 1990 and started trading on December 19, 1990. The Shenzhen Stock Exchange was formally founded on December 1, 1990, and it started trading on July 3, 1991. While the largest and most established companies usually trade on the Shanghai Stock Exchange, the Shenzhen Stock Exchange is home to smaller and privately-owned companies. Taken together, the Shanghai and Shenzhen Stock Exchanges represent the second largest stock market in the world after the New York Stock Exchange.

On November 17, 2014, the Chinese government launched the Shanghai-Hong Kong Stock Connect to enable investors in either market to trade shares on the other market. This initiative heralds closer integration between securities markets in China.

Chinese companies may list their shares under various schemes, either domestically or abroad. Domestically, companies may issue:

  • A-shares: common stocks denominated in Chinese Reminbi and listed on the Shanghai or Shenzhen stock exchanges.
  • B-shares: special purpose shares denominated in foreign currencies but listed on the domestic stock exchange. Until 2001, only foreign investors had access to B-shares.

In addition to B-shares, foreign investors interested in the Chinese equity market may also buy:

  • H-shares: shares denominated in Hong Kong Dollars and traded on the Hong Kong Stock Exchange.
  • L-chips, N-chips and S-chips: shares of companies with significant operations in China, but incorporated respectively in London, New York and Singapore.
  • American Depository Receipts (ADRs): an ADR is a negotiable certificate issued by a U.S. bank representing a specified number of shares in a foreign stock traded on an American exchange. As of October 2015, there were around 110 Chinese ADRs listed on American exchanges and another 200 Chinese ADRs on American over-the-counter markets.

Predicting Chinese Stock Market Crashes

Predicting Chinese Stock Market Crashes

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