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Not so crazy: Why the huge drop could be rational

The stock market has suffered wild swings over the past two weeks, declining sharply before staging a powerful two-day bounce that erased some of the initial losses.

Read MoreThe markets were a roller coaster this week

The speed of the moves, particularly after a long period of market quiescence, has led some to suggest that the market is dominated by thoughtless "algos" (or automated) trading—or perhaps is simply irrational.

But in fact, there may be a way to make sense of the swift move lower—if not on an day-by-day basis, then at least in a slightly broader context. Indeed, a classic finance paper dating back more than a decade may provide a coherent explanation behind why markets might be crazy like a fox.

Why it all makes sense

A screen displays news on the Dow Jones Industrial Average on the floor of the New York Stock Exchange, Oct. 15, 2014.
Brendan McDermid | Reuters
A screen displays news on the Dow Jones Industrial Average on the floor of the New York Stock Exchange, Oct. 15, 2014.

For starters, it has been widely acknowledged that the slowdown in China and the crashing of Chinese stocks is the fundamental cause of the market selloff.

Now, there's nothing particularly new about China anxiety—over the past few years, China's potential "hard landing" has become one of the better-known economic clichés.

Read MoreDon't blame China for volatility: Strategist

Yet the three month-long Chinese stock crash has certainly put a finer point on it, turning a long-simmering concern up to boil. Worse, it has been joined by a chorus of economic troubles across the global economy.

Believe it or not, some say it all makes sense.

"To me, the slide is rational," Neil Azous of Rareview Macro wrote to CNBC. "The medium-term upside in risk assets become more capped in a world where liquidity is being removed by both the US and China via possible higher (U.S.) interest rates and defense of a (Chinese) currency," he explained.

Moreover, the picture is further clouded by a "negative growth profile in synchronicity for the first time–that is, a US GDP second half of the year overhang, a Japanese consumption led-recovery faltering, [and] Europe reverting back towards" slow growth that characterized the economy before the European Central Bank's easing efforts," Azous added.

As ever, China remains "extremely difficult to read," he said —meaning a whipsaw market makes all the sense in the world.

'Rational expectations'

This is all taking place as the prospects for the domestic economy, and by relation U.S. companies and their share prices, become increasingly uncertain.

The U.S. has clearly escaped the grips of the recession, but the road now appears to be getting rockier. Some economists are still holding out hope for growth to break out in the years ahead, but others believe the global slowdown makes that a pipe dream. The very idea of America's expansion continuing is under increasing strain.

At times like this, it is only natural for bad news or bad "stories" to have an outsized effect. It is a phenomenon best explained by University of Chicago economics professor Pietro Veronesi's widely cited paper, "Stock Market Overreaction to Bad News in Good Times: A Rational Expectations Equilibrium Model."

"Investors' willingness to 'hedge' against changes in their level of uncertainty makes them overreact to bad news in good time and underreact to good news in bad times, making the price of the asset more sensitive to news in good times than in bad times," Veronesi wrote.

The key to this point is that on the whole, investors are generally risk-averse, meaning that they hate losses more than they love gains. For that reason, in times of economic expansion, negative news poses greater a risk, as it threatens to have a deleterious effect on the state of the economy. That potentially shifts likely returns into a worse zone.

For that reason, investors must be "compensated" for the bad news twice:once because the news is bad; and a second time because it may result in lower-returns. The end result, of course, is lower prices (since lower prices now translate into higher expected returns tomorrow).

The recent market drop is a case-in-point. Bad news out of China is bad—but in addition, it threatens to derail the U.S. recovery. Since this risk makes holding stocks more risky, it must also lead to an even deeper drop in prices than the news alone would warrant.

To be sure, sudden decline due to headlines may or may not be rational in a strict sense of the term, whereby stock prices are attempting to predict future earnings or dividends. Yet once one considers that investors are risk-averse, what initially looks like an overreaction begins to make more sense.

Of course, this risk-aversion itself may or may not be irrational. But either way, it is a part of human nature that an investor must learn to contend with.

—By CNBC's Alex Rosenberg.

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