Betting Against China

01/25/2010 10:46 am EST

Focus: ETFS

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carl Delfeld, managing editor of ChartwellETF.com, says he thinks China’s market is way overvalued, and he recommends a speculative way to play it.

There are a plethora of reasons I believe that the Chinese markets are overvalued and vulnerable.

The adjusted “Graham-and-Dodd” price-to-earnings ratio—a time-tested indicator of value, which uses an average of ten years earnings—remains at a dizzying 50x. Compare that with around 15x in the US, itself by no means cheap in historical terms.

Residential real estate appears to be even more overvalued. In bubble-era Japan, a byword for manic real estate speculation, apartment prices peaked out at 12x to 15x average household income. In major Chinese cities, the multiple is currently 15x to 20x.

The biggest distortion in the Chinese economy is the explosion in fixed-asset investment to an eye-popping 50% of GDP. By comparison, Japan in its miracle decade clocked up economic growth rates similar to China’s today by investing between 30% and 35% of its GDP.

The People’s Bank of China raised the amount banks must set aside in reserves, in an attempt to cool an overheating economy. But it raised fears among some investors that it would result in reduced demand for resources and possibly slow trade flows.

Commercial lending by Chinese banks grew more than 45% between July 2008 and July 2009, according to data from Swiss Re. “China is on a very unbalanced path of economic growth,” said Daniel Hofmann, group chief economist at Zurich Financial Services, the global insurance group.

Housing price appreciation in China increased its pace in December, climbing 7.8% from the same month a year earlier and prompting new government measures as Beijing attempts to slow soaring prices without derailing the economic recovery.

The reason I am targeting UltraShort FTSE/Xinhua 25 Proshares (NYSEArca: FXP) is that it moves inversely double to the well-known iShares FTSE/Xinhua 25 Index (NYSEArca: FXI) ETF, which is a basket of China’s largest 25 companies listed in Hong Kong.

The reason is that banks in China seem the most vulnerable to me, and that FXI has 46% exposure to the financial sector. Chinese banks are at the top of the range in price-to-book value. FXI [has] high exposure to banking—almost 20% more than the iShares MSCI Emerging Markets Index (NYSEArca: EEM).

FXI has also been a near-term down trend since mid-November. In fact, for nearly the last two months, FXI has been on a course of hitting lower lows.

The risk factor is high. I highly recommend a 5%-8% trailing stop loss. If you wish to hedge your bets with a long China position, I suggest Claymore/AlphaShares Small Cap (NYSEArca: HAO), which has outperformed all China ETFs with a whopping 114% return in the past 12 months. The ETF holds 157 stocks that have market caps of $1.5 billion or smaller.

(Editor’s Note: Double inverse ETFs are only for the most risk-tolerant investors who can afford to lose their investment. They are primarily trading vehicles, not long-term holdings.)

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