Quotes of the Day

Chen Jing was one of the lucky ones. The 56-year-old retiree, who lives in Shanghai, dabbles a bit in local stocks, exchanging investment tips with what she calls her "mah-jongg friends," a group that gets together each week to play and chat. Just before the Chinese New Year holiday last month, one of her friends spoke ominously of rumors that China's government was planning a crackdown on stock speculation, including a possible tax on capital gains. Over the past 18 months, Chen's small portfolio had almost doubled in value as the Shanghai market shot straight up. So she decided to pull the plug, suddenly afraid it would all go sour. "I sold everything just before the holiday," she says, and was blithely unaware that the Shanghai stock index plunged 8.8% on Feb. 27, its biggest one-day drop in a decade.

Roller-coaster rides are not unusual for China's stock markets, which sometimes resemble a casino in Macau. What happened next, however, was decidedly unusual. Investors in New York's equity markets woke up, saw that Shanghai had tanked, and had a collective heart attack: they sent the Dow Jones industrial average down more than 400 points, its biggest single-day drop since Sept. 17, 2001—the first trading session after the terrorist attacks of 9/11. The drop in New York, in turn, fueled fear in markets across Asia the following day, and suddenly investors were seized by visions of a rerun of 1997's "Asian contagion," when a financial crisis in Thailand triggered stock crashes from Jakarta to Moscow to New York. On Feb. 28, as this new outbreak of investor gloom spread, India's main stock index tumbled 4%, Singapore's dropped 3.7%, Japan's fell 2.9%, South Korea's lost 2.6%, and Hong Kong's slipped 2.5%.

This chain reaction plainly demonstrated the increasingly prominent place China now occupies in the minds of global investors. Its extraordinary economic rise has been a key reason for soaring demand for everything from copper to oil to cars, much to the benefit of multinational and Chinese companies alike. But while investors are right about China's economic importance to the world, they're clearly still confused about how to interpret a decline in Chinese stocks. There's little question that the reaction to China's market swoon was overwrought, and that this is not a replay of 1997. Rarely, if ever, has the global economy been stronger than it is now—one reason why so many stock markets have been so healthy for so long. If anything, what the Shanghai shock provided was a reason for investors—finally—to get real: relentlessly rising stock prices virtually everywhere had dulled their sense of risk to the point where "anything—somebody sneezing—could have triggered this," says Sean Darby, head of regional strategy at Nomura International in Hong Kong. "We've ignored risk globally for a long time."

Indeed, before this sudden attack of fear, China's market had risen 11% in just six trading sessions, having already soared an astonishing 130% last year. It was about time for a sharp reminder that what goes up occasionally comes down. That said, many China bulls were soon back in the game: on Feb. 28, much to the doomsayers' surprise, Shanghai's main stock index jumped nearly 4%.

In any case, given a day or two of reflection, global investors should begin to realize that what happens to China's stock markets actually has little bearing on the nation's white-hot economy, let alone on other countries' economies. In China, "the stock market is really, really small compared to the overall economy," says Michael Pettis, a professor of finance at Peking University and an expert on China's markets. "Participation is limited. You're not going to see a wealth effect"—a decline in consumption because people feel poorer when stocks fall—"and companies don't use the market as a major tool of financing." Investors who thus savaged the stock of, say, Caterpillar Inc., a heavy-equipment maker in Peoria, Illinois, because they feared the company's booming China business was suddenly going to fall off the cliff should probably rethink that a bit. As Jun Ma, the chief economist for greater China at Deutsche Bank in Hong Kong, says, "We do not see any significant impact of this market correction on China's real economy. We remain bullish on the fundamentals of the economy," which is still steaming ahead this year at a growth rate of nearly 10%.

A more sensible explanation for the panicked reaction in other markets to the tailspin in Shanghai is that it was simply an excuse to take some money off the table. The Dow Jones industrial average, for example, had recently hit all-time highs, having gone up for five straight years as American corporate profits soared. There hadn't been a single day in nearly four years in which U.S. stocks had fallen even 2%, an unusually long absence of volatility. Likewise, global markets from India to Singapore to Russia had been on a historic tear. Against this backdrop, China's sudden return to earth was a reminder that risk still exists and that widespread euphoria may have led investors to lose sight of economic reality.

It was certainly no coincidence that this week's outbreak of market jitters came on the heels of some disquieting economic data. On the same day that Shanghai stumbled, the U.S. Commerce Department reported that orders of durable goods in America—a key indicator of economic health—had fallen sharply in January. That followed an unnerving speech by someone many consider the great economic forecaster of our era, former Federal Reserve Chairman Alan Greenspan. On Feb. 26, he warned in a speech that investors couldn't rule out the possibility of a U.S. recession in 2007, noting that corporate profit margins "have begun to stabilize, which is an early sign we are in the later stages of a cycle." Most economists had figured the U.S. was downshifting from a growth rate of 3.5% to about 2%, but few had predicted a recession. Greenspan's warning was particularly chilling because the truth is, the health of the massive U.S. economy—not the performance of Chinese stocks—is the single most critical variable that global equity investors confront.

That helps to explain why, for example, Japan's stock index took such a hit on Feb. 28 after approaching a seven-year high earlier in the week. Toyota, Sony et al would surely feel it if a slowdown in the U.S. proves sharper than expected. But will it? On the same day that the dismal durable-goods number came out, a monthly survey of U.S. consumer confidence rose unexpectedly, and so did the latest figures for existing U.S. home sales. In other words, a painful U.S. slowdown is not, by any means, a given. And for those who are suddenly taking their cues from China, there is also this heartening thought: the Chinese have just welcomed in the Year of the Pig on the lunar calendar, which means investors in the U.S., at least, should be delighted. According to an investing website called the Kirk Report, in all but one Year of the Pig since 1935, both the Dow Jones industrial average and the S&P 500 have gone up—usually sharply. Of course, it's true that the past doesn't necessarily predict the future; then again, neither does the Shanghai stock market.

• Bill Powell/Shanghai