By definition, fear and  greed mark periods of irrationality. These evil twins of speculation signal a move away from investment and into a world in which rumors, gossip, and irrational behavior rule the landscape. In the current market, a whisper of a potentially undesirable German Parliament vote could send markets down 3%.

History and psychology indicate that this is simply a bear market strung along by fear, an irrational decline that, although troublesome, will eventually return to “normal” levels. But even though the current stretch of fear is prolonged, intense, and volatile, the sobering backdrop of global financial crises and an extended recession continue to loom over the market.

Then perhaps the fear isn’t fear at all, but a justified symptom of a changing financial system.

Domestic macroeconomic issues include lagging unemployment numbers, slow GDP growth and a tremendous decrease in investment. On top of that, the housing market has begun to decline once again, corporate profits have taken another beating, and banks again are rumored to be undercapitalized. “There are issues about the weakness of banks and uncertainty about how the government will respond to another banking crisis,” says Professor Zitzewitz, an economics professor at Dartmouth College.

Even bigger issues lie overseas – the prolonged Greek debt crisis, and concerns over the solvency of Italy, Spain, and Portugal, threaten to send the Eurozone into a financial crisis of epic proportions.

With all of these potentially disastrous domestic and international issues, Thomas Flexner, Global Head of Real Estate at Citibank, believes that the market is behaving somewhat rationally. “This is reasonable fear based on the uncertainty of the markets,” he says. “Irrational implies that the fear is misplaced or unfounded.”

If, indeed, the fear is rational, then the consequences are severe. It suggests that the incredible world economic growth over the past several decades has been inflated.

“In the past twenty years, global markets were magnified by credit creation – easy central bank policies and easy leveraging created credit that turned into purchasing power, propelling global GDP,” says Flexner.

The debt owed to the creditors has to be paid back, slowly and painfully. This paying down of debt could drastically limit the advance of the global economy for many years. If our fears come true, then we could be entering a new economic reality of shrinking credit and a diminished financial  system.

At the same time, some investors continue to make big bets on our financial system, confident that the American economy can come out of the recession unscathed and unchanged. Some might argue that the bear market has been exaggerated, that although some of the concerns are real, the sharp decline in the equities market has been intensified by fear and rumor-mongering.

On August 18th, 2011, the Dow declined a whopping 415 points based on a “trio of disappointing economic readings” and a Morgan Stanley report that the US and Europe may be heading for another recession.

Those losses were erased a few days later as the Dow posted consecutive gains of 322 and 145 points based on an “FDIC report that the number of US banks in trouble is declining.” The Dow slipped 388 points on September 22nd, 2011, for a 3.48% loss based on “several reports…warning of the dangers of another global recession.”

Again, the losses were erased by a 272 point rise two days later on rumors that the German Parliament would vote to expand the bailout fund for Greece.

From this, it seems that the extreme upswings and downswings in stock prices can be attributed to only a few economic reports. To a rational observer, a few poor (but far from disastrous) economic readings should not lead to a 3.48% decline in the blue-chip stock index of the most financially powerful nation in the world.

The tremendous attention that investors are paying to small,  insignificant data points may be evidence that the levels of fear currently exceed market rationality. “The market is moving around more than justified by the news,” Professor Zitzewitz says.

The fear could be stemming from group psychology. The closeness of the financial community, in which relationships rule all, could potentially lead to prolonged bouts of groupthink in which traders and investors move together in herd behavior, acquiring information only from those already within the circle and of the same mindset.

As a result, the effects of a single, unfounded rumor is intensified as it moves through the collective conscious of the financial markets, unchallenged by outside analysis.

Prospect theory also suggests that people who have already achieved gains would be risk-averse, while those who have suffered losses become risk-loving.

It’s possible that as investors received overwhelmingly favorable returns in 2009 and 2010 have now become risk-averse, and even the slightest tremor in the financial bedrock would lead them to quickly shift their investments to less risky instruments.

Ironically, it is the very fear that leads investors to take their money out of stocks that makes the stock market decline. The actions of the investors are a self-fulfilling prophecy.

The fear, volatility, and global decline in financial markets may not be justified, but by their very existence, create an environment that reaffirms their fear.

As Flexner states, “Fear, unfortunately, becomes self-fulfilling. It’s investor’s fear that creates redemptions, forces hedge funds to sell their liquid assets, and eventually decreases the values of those very assets. That’s the biggest problem with fear. Fear in the financial markets transmutes itself into  reality.”

There is no denying the growing interconnectedness between the Chinese and American financial markets. Like other global financial centers, upswings and downswings in either the Shanghai Stock Exchange or the New York Stock Exchange have often been preceded by similar trends in the other. The surplus of recent global financial headlines and heightened index volatility appears to have strengthened this relationship. A simple investment simulation suggests that the Shanghai Stock Exchange can be moderately useful as an intraday trading strategy for the Dow Jones Index during the current periods of volatility.

Although this correlation has not always been present, the Chinese and American markets have gradually shifted toward each other. From 1993 to 2001, the Dow Jones Index China had only a 0.0332 correlation coefficient with the Dow Jones Industrial Average, suggesting no observable correlation. But a loosened economic policy has led to more intertwined financial markets between the U.S. and China. From 2000-2009, the correlation coefficient between the Shanghai Stock Exchange and the Dow Jones had risen to 0.731, indicating a strong  relationship.

The trading strategy I’ve tested is quite simple: use a moderate rise or drop (0.85% or more) in the Shanghai Stock Exchange (SSE) to invest in the same direction in the Dow Jones when the New York Stock Exchange opens, six and a half hours after the SSE closes. For example, if the SSE opens at $100 and closes at $100.86, then I would buy shares long on the Dow since the SSE gained greater than 0.85%. If the SSE closed at $99.14, I would short the Dow.

After running this model from 04/20/09 through 10/14/11, excluding the holidays of both exchanges from the model, the total return was 83.81%, with annualized returns of 27.57%. The hit rate for positive gains, in which a 0.85% increase in the SSE led to any positive gain for the Dow, was 64%, while the hit rate for negative gains was 54.55%. Total return from positive gains was 44.62% and total return from negative gains was 39.19%.

With a modest hit rate but a significant return, this trading strategy seems to capitalize on the volatility of both exchanges. Essentially, when the Dow goes in the same direction as the SSE, it’s able to rise or drop high enough to offset the losses incurred when it goes in the opposite direction as the SSE. Moreover, it seems that those losses incurred are also quite minimal. As a result, although this trading strategy does not have a very great predictability factor for total positive or total negative gains, it does suggest a sort of dual volatility.

This should come as no surprise. The rise of a deeply intertwined and globalized financial market has inevitably strengthened the relationship of the Chinese and American financial systems. At the same time, financial crises with implications for the world economy have increased volatility and shaken investor confidence. Although this is not a long-term trading strategy, it may have strong returns in the near future by taking advantage of the US-China correlation and world market volatility.