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.