China Is Due for a Turnaround

09/25/2008 12:00 am EST

Focus: MARKETS

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, says Chinese stocks are dramatically oversold, and the market may head higher again.

During the four-year bull market, the US stock market significantly underperformed various emerging stock markets, like China. Most noncommodity-industry US stocks were flat in 2007, with financial and housing stocks down sharply. So, US-based investors seeking higher returns pumped $404 billion into emerging-market mutual funds in 2006 and 2007.

Once Chinese stocks started to correct, though, investors panicked and started throwing babies out with the bathwater in January. So the sell-off in China spread to other non-commodity based stock markets as funds flowed out of emerging markets back into the US.

The magnitude of these corrections is jaw dropping. The Shanghai Composite Index—an index of Chinese stocks listed in mainland China—is down [more than] 60% for the year. It has given back last year's 90% gain and then some. Chinese stocks listed in New York and Hong Kong have declined by 34% year to date.

Despite the sell-off in Chinese stocks, the long-term fundamental picture changed very little. China is still the world's fastest growing major economy, growing at 10% this year. And nonexport, blue-chip Chinese companies continue to grow earnings at 20%.

However, from a technical perspective, the Chinese markets were severely overextended on the up side and have broken important support levels on the downside, signaling that momentum has changed.

The magnitude and velocity of these market moves have only been even more exacerbated by the proliferation of hedge funds, proprietary trading operations, and other aggressive investment vehicles. So, predicting a bottom right now is nearly impossible.

[So,] when will Chinese stocks resume their powerful up trend?

Beijing policy makers [are moving] more aggressively to stimulate the economy, and now that inflation has come under control, [they] have more wiggle room to do this.

And if the Chinese government is back to focusing on growth, that makes me more optimistic about Chinese stocks. I expect them to be the first to have a meaningful recovery and actually lead other emerging markets to a recovery as well.

Here's why: the indiscriminate selling by mutual funds, hedge funds, and investment banks are creating attractive valuation opportunities in Chinese stocks for long-term investors. In fact, the Chinese domestic A-Share stock market in Shanghai is now trading at its cheapest level ever—14.4x 2008 estimated earnings, down from 50x last October.

The last time we saw valuations at these record-low levels, it was followed by a 500% run-up in A-share stocks. While it may not be as big of an increase this time around, I still think that we will likely see a year-end rally in Chinese shares.

[Yet] the road to higher Chinese stock prices later this year might be bumpy, which makes aggressive bargain-buying risky business right now. But if we keep our eyes on the horizon, there are much better investing days ahead, and I continue to be cautiously optimistic.

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