By Dr. Brad Cornell
In an article recently published in the Wall Street Journal, Alan Blinder asks a question that has puzzled many – why does the U.S stock market seem to drop on bad news from China or when oil prices slide? As Prof. Blinder rightly observes, exports to China make up less than 1% of U.S GDP. Furthermore, because the U.S. remains a net importer oil, falling oil prices saved the U.S. over $100 billion dollars in 2015 alone. How can such savings be bad news for the American market? True the U.S. oil and gas industry has suffered, but as Prof. Blinder notes employment in U.S. oil and gas extraction is one-eighth of 1% of total non-farm employment. All this seems to make the reaction of the U.S. stock market to China and to oil, as Prof. Blinder says, slightly nutty.
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But there is a more rational explanation. Much of the research in financial economics in the past several decades has focused on what have been called “factor models.” Eugene Fama won the Nobel Prize in 2014, in part, for work related to factor models. The idea is simple – stock prices worldwide tend to move together because they are responding to a limited number of common factors. The problem is that to date there is no objective procedure for identifying the factors. As a result, an untold numbers of scholarly papers have been written suggesting what the factors ought to be. While there is still no consensus on the precise identity of the factors, a common suspicion is that they are related to investor expectations regarding key macroeconomic variables such as world economic growth and inflation (or deflation) in major global economies.
Though the factor models imply that virtually all stock and commodity prices respond to the same basic factors they do not respond with the same intensity or even in the same direction. According to the models, it is the intensity of its response to the factors that determines the risk of an investment. The differential response to the factors can also explain, at least in part, the relation between Chinese stock prices, oil prices and U.S. stock prices. All three are responding to the same factors so it is no surprise that they move together. However, given then the fragility of the situation in China and the nature of the companies that trade on the Chinese exchange, Chinese stocks are more sensitive to the factors. Therefore, negative factor innovations lead to large drops in Chinese stocks and smaller declines in American stocks.
The drop in the price of oil is far too large to be explained by factor sensitivity alone. In the case of oil, much of the responsibility for the price collapse must be laid at the feet of producers who have been unwilling to cut output in the face of falling prices. Nonetheless, there is every reason to suspect that oil is also responding to the same factors that have affected American and Chinese stocks. The bottom line is the U.S. markets are not reacting to China or to oil. They are responding, in a more muted fashion, to the same factors affected Chinese stocks and oil prices.
California Institute of Technology
Pasadena, Ca 91125