Editor's Note

02/19/2007 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

This week Chinese families around the world give their children bright red envelopes filled with "lucky money" to celebrate the lunar New Year.

Kids whose parents invested in Chinese stocks should do particularly well: The Shanghai Stock Exchange composite index topped 3,000 for the first time last week before closing for the holiday, after having more than doubled last year.

Americans who bet on China have prospered, too. Eight of the ten top-performing U.S. mutual funds last year specialized in Chinese stocks.

But hold the fireworks, folks.

The Chinese market is showing all the signs of a classic bubble. So, not only wouldn't I be buying now but I would take some profits and put the money into unloved, unexciting U.S. blue chips. As the headline says, sell China, buy American.


I say this not out of patriotic fervor but as a contrarian who pays close attention to extremes of sentiment. And I'm not the only one. At last week's World Money Show in Orlando, Florida, several investment luminaries expressed caution about the boom in Chinese and other emerging markets. Diversified emerging-market funds have surged by 27% annually over the past three years, according to Morningstar.


But China looks particularly overheated. A couple of weeks ago, The Wall Street Journal reported that "in recent weeks individuals have been opening stock-trading accounts at the rate of about 90,000 per day, 35 times the pace of a year earlier."


"Investors," the Journal continued, "are pledging their homes as collateral for personal loans, or teaming up with merchants to, in effect, borrow from their credit cards, presumably hoping that stocks will rise enough before the bill comes due to pay off the debt."


And you were worried about a mere margin call?


That week, Cheng Siwei, vice-chairman of the Chinese National People's Congress, used the "B" word in an interview with the Financial Times.


"'There is a bubble going on. Investors should be concerned about the risks,'" said Mr. Cheng, whom the FT described as "an influential figure."


Chinese investors took heed of the jawboning-for an instant: The Shanghai exchange lost 11% of its value before heading skyward again.


And why not? The growth rate of the Chinese economy tops 10% per annum. It is now the manufacturing workshop of the world. Its central bank has amassed some $1 trillion in currency reserves. Tens of millions of once-impoverished peasants and laborers are becoming middle-class consumers in one of the great wealth transfers in human history.


Unfortunately I think a lot of that good news is already in the price of China's shares.


At the World Money Show, where 10,000 individual investors heard experts hold forth on markets from Germany to South Africa to India and Australia, some speakers warned the frenzy couldn't last. (This week's Money Show Digest features excerpts from some of their workshops and panels.)


"My next move [in emerging markets] is to take money off the table, largely because China is a bubble," said Jack Ablin, senior vice president and chief investment officer of Harris Private Bank in Chicago.


What could cause it to burst? Any number of things. The dark side of the Chinese miracle has been well documented by MSN Money columnist Jim Jubak and others: rampant corruption, a banking system riddled with bad loans, massive dislocations in the countryside, a restless labor force that has staged thousands of strikes.


Or maybe an outside event like a sudden surge in oil prices will be the culprit.  Who knows when it will happen? But trust me--it always does, eventually.


Rapidly growing economies can generate huge stock-market gains. But they come with much higher risk. Just last May, when fears of higher interest rates caused U.S. stocks to suffer an 8% correction, emerging markets lost as much as a quarter of their value within weeks. But everybody's forgotten that selling panic as these markets have gone on to even giddier gains.


Right now the risk again outweighs the potential rewards, which is why I would take some profits in China and any other emerging markets in which you've had outsized returns. I don't think you should have more than 5% of your portfolio in emerging markets stocks anyway. I'd cut that weighting to 3% for the time being.


With the proceeds, I'd buy American. U.S. blue-chip growth stocks have been near the bottom of the performance tables every year since 1999. These steady growers like Johnson & Johnson, Procter & Gamble and IBM aren't going to make you rich overnight, but when the high-flying markets collapse, they'll hold up well and they often pay good dividends. 


And guess what? Because these big U.S.-based multinationals get upwards of 40% of their sales from overseas, they're a much less risky way to play international growth-and they benefit from a weaker dollar to boot.


A couple of ways to invest in this group-besides buying the individual stocks--are the iShares S&P 500 Growth index ETF (IVW) and either the Vanguard Growth ETF (VUG) or the Vanguard Growth index mutual fund (VIGRX), which track the same benchmark.


I can hear the yawns already, especially from those of you who are comparing these plodders to the thrills and chills of emerging markets over the past few years.


But which would you rather have bought in early 2000: tech high-flyers like Akamai Technologies and JDS Uniphase or energy, small-cap and precious-metals stocks, which were thoroughly scorned at the time?


Think about that while you're opening your red envelopes and counting your lucky money. Happy New Year!



Starting next week, you will see some exciting changes in the Money Show Digest and moneyshow.com. Watch for an email with all the details!


Howard R. Gold is editor-in-chief of MoneyShow.com. The views in his commentary are his own and do not necessarily represent those of InterShow.

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