China: A Bubble or a Buy?

06/15/2015 10:00 am EST

Focus: ETFs

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

Is China a bubble or a still-unfolding, long-term buying opportunity? Doug Fabian, editor of Successful ETF Investing, addresses this question, highlights both sides of the debate, and reviews a trio of exchange-traded funds for investors seeking exposure to the China markets.

Steven Halpern: Our guest today is ETF expert Doug Fabian, editor of Successful ETF Investing. How are you doing today, Doug?

Doug Fabian: Doing great, Steven.

Steven Halpern: You've been invested in China for quite some time, and with the market now at seven-year highs, you've obviously seen significant gains.

Now, before we look at the bullish side of the equation, could you highlight the concerns that have caused some market observers to worry that China stocks could be approaching a bubble.

Doug Fabian: Well, I have to say, Steve, that the bubble talk in China is very robust. There are a lot of people concerned that the, you know, China stock market and certain China indices are now way overvalued. Let me go through some of the points that those observers are making right now.

First of all, over the last six months, you know, China has had a very high level of IPO activity. Now, IPO activity, of course, is, you know, an indication that capital markets are functioning; a lot of people are involved in capital markets.

We understand IPOs, which have a long history here in the United States. But over the last five years, there has been virtually no initial public offering activity in China because they were in a bear market and there were a lot of worries about contraction in the Chinese economy.

Now, this high level of IPO activity is really, you know, part of a new bull market in China, so I believe that that is okay.

Second, there is, you know, many different market indices in China and Chinese technology stocks have had a very, very big gain over the, you know, shorter-term, let's say the last six to 12 months, so there are very high valuations of many tech stocks in China, some of them are relatively new companies that don't have earnings.

Well, we certainly know what that's all about here in the United States with some of the social media companies and going back to the, you know, late 90s when we had our big tech market bubble. We understand high valuations of tech stock, so I have to say that that's an area that has to be monitored going forward.
Then there's two things happening internally with the Chinese people who are now investing in the stock market.

We have margin interest at all time highs, and also, the number of brokerage accounts that had been opened in China over the last 90 days is more brokerage accounts that had been opened in the last four years, so people are saying, "Hey, a lot of, you know, Chinese citizens are now getting involved in the stock market; isn't that sign of a bubble?"

Well, you know, certainly I can't see the future and, you know, all bull markets come to an end, but I believe that we're still in the early stages of a China bull market, and there's going to be volatility, but there's still ways to be able to make money.

Steven Halpern: Now, you've highlighted the potential worries and you still walk away with the view that there are still gains ahead. Could you discuss some of the longer-term fundamental factors that cause you to remain optimistic?

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Doug Fabian: Certainly, Steve. Let's take a look at, you know, bull markets in general. Investors have to understand they have to look back at history and realize that bull markets last longer than bear markets and bull markets overcome previous bear markets and then go on to new highs. That's exactly what we've got going on in China.

This bull market is one-year-old. The previous bear market was three years in China and so, granted, we've already overcome the previous bear market in major China indices with them hitting new recent highs; they haven't gone back to all time highs yet, but bull markets last three, five, seven years.

And again, the whole reason why we're in a new bull market in China is because there is belief that the Chinese economy is going to turn around and have more robust growth in the future, and realize, the Chinese economy right now is still growing at 7%.

Don't we wish we had 7% growth in the United States? I think that, you know, just, logically, you could look at this and say, "Hey, you know, if this is a new bull market, if the Chinese economy is going to recover, then there's going to be higher stock prices going forward."

Now second, valuations of certain China stocks are still very reasonable; less than the US. When you look at major large companies in China, and one of the ETFs that I monitor is iShares FTSE/Xinhua China 25 Index (FXI), this is the largest exchange traded fund from iShares and it's almost like a Dow Jones Industrials for China.

There's only 30 stocks in the index and these are the large banks, insurance companies, Telecom, Energy, you know, this index is trading at a valuation of a 13-14; well, the US S&P 500's trading at an 18. There's still room to grow in terms of the large-cap stocks in China.

Next, we have the Chinese government that is very committed to reforming its economy, and again, the biggest reform that happened in the last 12 months was the opening up of the China A-shares.

The Chinese government is standing behind their economy and they have the ability to lower interest rates, they have the ability to stimulate the economy, and they don't have Democrats and Republicans in China; they just have one political party, so they can just get things done. They don't have to go to Congress or any of the nonsense that has to happen here in the United States.

Lastly, I believe that the Chinese economy is underestimated in global stock market indexes and underweighted by managers around the world, and so, we have rebalancing that's going to be huge for China stocks going forward.

Steven Halpern: Touching on that last point, there is a big decision pending related to how China stocks could be included in emerging market indices.
Could you explain this wildcard and the potential impact that it would have on investors in China?

Doug Fabian: Certainly. Well, we have to realize that exchange-traded funds are now the fastest growing investment vehicle globally, not just in the United States, but there are ETFs in China, there's ETFs in Hong Kong, in Singapore, in Europe, in Australia. Every major stock market in the world is offering ETFs to its local investors.

ETFs are index based and there are all kinds of indexes that have been created around the world. We know the S&P 500 is an index that is created by Standard and Poor's. There's a company called MCSI; they have major market indexes; FTSE, Russell, all these different companies have indexes that they create on their own methodology.

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As it stands today, China's representation in global stock market indexes is extremely low. Matter of fact, with the Morgan Stanley index organization, China's economy is ranked the same size as Spain.

Well, China is so much bigger than Spain, so if they do go through a rebalancing, and one company, the FTSE—these are the people that the Vanguard uses—they've made the decision to increase the waiting in China already.

Well, if all market indexes start to get on board with the fact that the Chinese economy is the largest economy in the world and their stock market needs to have larger representation in these indexes, this is going to force money managers around the world to have to buy China stocks and that could be huge for a continuation of the bull market.

It's not going to happen overnight, it's not going to be a one-day deal, but this could add another 100% to the China stock market in the next 18 months. I'm very, very excited about this and we're going to find out about what's happening with these investments going forward in the weeks ahead and it could be very positive news for the Chinese stock market going forward.

Steven Halpern: Now, for those interested in having China stock exposure in their portfolios, you've already mentioned the FXI, which is the large cap index; are there any other ETFs that you would recommend investors consider?

Doug Fabian: Well, I believe that, you know, people should stay with the larger indexes right now; FXI, there's another one, the iShares China MSCI Index (MCHI), and then there's the A-share index from Deutsche Bank X-Trackers Harvest CSI 300 (ASHR) and that's an investment in 300 of the A-share stocks and it's one of the first ETFs that had access to A-shares.

Those three, I do in my newsletter, Successful ETF Investing. I've been recommending FXI and ASHR for the past 12 months and I still have them recommended in my newsletter and I'm confident that there are still buying opportunities to be had with these ETFs right now.

Steven Halpern: Now finally, we only have a minute left, but given the volatility of the China market, you discuss a strategy with your newsletter readers that suggests how they could scale into positions rather than jumping in all at once. Could you explain this approach?

Doug Fabian: Absolutely. This goes back to something that my dad, you know, kind of developed, you know, over 30 years ago with our newsletter helping people get on board in bull markets. Let's take a simple sum of money and let's say you want to invest $12,000 in China.

You would start off investing one-third of $12,000, which would be $4000, and then you would wait, you know, 30 days and if, you know, if the index or the China ETF were to pull back 5% or 10%, that's just, you know, another indication that it's time to add to your investment portfolio.

After 30 days you would add another third, another $4000 in this case, so it gives you the opportunity to kind of average in over a 90-day period of time in three increments the amount of money that you want to get invested in China.

Now, we do use stop losses in our strategies and so, you know, again, I can't get into the details of our stop loss strategy here because it's changing all the time, but we do manage risk with Successful ETF Investing using stop losses, and if you are putting a stop loss on a China ETF, I think it would have to be a stop loss of 20% or 25% because of the big run that it had already.

Steven Halpern: Again, our guest is Doug Fabian of Successful ETF Investing. Thank you for your insights.

Doug Fabian: Thank you, Steve.

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Editor's note: Doug Fabian adds this update based on news that broke just after our interview. He explains, "MSCI Inc. decided it would add China A-shares to the MSCI Emerging Markets Index, just not quite yet. The deferral to begin adding A-shares later this year (as opposed to right away) disappointed some China bulls, but it should't have. In fact, knowing that mainland Chinese stocks will become part of the index just means more time to get long A-shares before all of the index-based advisors out there are forced to flood into the market."

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