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Why a Chinese bear market doesn’t spell trouble for U.S. stocks

There’s surprisingly little correlation in performance

(MarketWatch) — Ready for today’s investment pop quiz? Which country’s stock market is the better performer over the past decade — China’s or the United States’?

I bet your answer was the U.S., since its stock market is in the sixth year of one of the most powerful bull markets in history. The Chinese stock market, in contrast, has just crashed.

But you’d be wrong. As you can see from the accompanying chart, the Chinese stock market — despite shedding a third of its value earlier this summer,including a 6.2% daily plunge earlier this week alone — is still well ahead of the U.S. for 10-year performance.

I stumbled across this surprising fact while trying to assess the likely impact of China’s recent market woes on U.S. equities. My hunch, before actually analyzing the data, was that I would find a significant historical correlation between the U.S. and Chinese stock markets, which, in turn, would lead us to worry that the U.S. market will soon fall in sympathy with the Chinese market.

Surprisingly, however, I found there to be little correlation. Consider a statistic known as the R-squared, which measures the degree to which fluctuations in one thing predicts or explains changes in another. The R-squared ranges between 0 and 1, with 1 indicating the highest possible degree of predictive power and 0 meaning there is no detectable relationship.

Over the past 20 years, according to data from MSCI, the R-squared between monthly changes in the Chinese and U.S. stock markets is only 0.25, which means that 75% of the monthly fluctuations in either stock market are undetectable in the other. To put that in context, the comparable R-squared between the U.S. and an index for all non-U.S. equities (as measured by MSCI’s EAFE index) is nearly three times higher, at 0.70.

Perhaps the most spectacular illustration of the low correlation between U.S. and Chinese equities came in the late 1990s. Between August 1997 and August 1998, the Chinese stock market suffered a crash that puts its recent drop to shame: The MSCI Chinese Index fell nearly 80%. The Wilshire 5000 index in the U.S. rose by 3% over the same period.

Be careful not to draw the wrong conclusion from the low correlation between the two stock markets. It doesn’t necessarily mean that U.S. stocks will rise as Chinese stocks suffer, for example. It instead means that U.S. stocks’ behavior has relatively little to do with what’s going on in China. In other words, U.S. equities could just as easily fall from here as rise. But if they do fall, it won’t be because the Chinese market is also falling.

The bottom line: If you have been worried about the fate of the U.S. stock market because of the Chinese market crash, you can breathe more easily.