The consensus about the consensus

CHINA FINANCIAL - In Brief 30 Jul 2015 by Michael Pettis

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I don’t know if this is indeed what triggered the selling, but on Thursday, July 23, following a string of uninterrupted up days, the market closed at a new recent high of 4,124, after which it dropped sharply every day for the next three days to close down by just over 11%, at 3,663. This is exactly what you would have expected if traders believed that the threat of significant sales when the index hit 4,500 was substantial, or at least if they believed that the market believed it. This expectation is what matters – or, more accurately, what matters is that everyone knows that everyone else is focusing on 4,500 as a break point. There may or may not be a great deal of selling likely to occur once the index hits 4,500 as brokers are forced by their weak capital positions to sell shares, and opinions vary on this point, but in this kind of market as long as investors believe that this is enough of a possibility for a consensus to form around it, they will act as if it were true. This means, then, that they will act like they have written a put option struck at 4,500, and unless they are absolutely certain that stocks will trade up right through 4,500, they are in the position of being able to cancel their short put any time they like simply by selling their shares. The market may or may not be thinking this way, but it has certainly acted like it might be. After those three bad days the market traded up on Wednesday by 3.4% to close at 3,789, but then lost faith again Thursday and dropped by 2.2% to close at 3,706. I expect it might make several runs at 4,500 before it breaks through.