Is China Bottoming Out?

06/07/2010 11:16 am EST

Focus: FUNDS

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carl Delfeld, managing editor of Around the World with, says China’s market has had a big sell-off, but its valuations look attractive.

[Recently] China entered a bear market for the second time in 12 months. Currently, China is down 23.4% from a peak on December 7, 2009

Since 2004, the CSI 300 index has had six declines greater than 20%. On average, the market loses 34.2%, and the decline lasts 88 days. Outside of the steep 2008 decline, the others were 22%, 21%, 25%, and 42%. Once the index breaks the -20% threshold, it declines an additional 48 days and 13.7%.

The last instance when the CSI 300 entered a 20% decline was August 19, 2009. The index fell an additional 4.9% before bottoming.

The Chinese real estate market continues to show signs of a bubble with prices in April increasing by a 53% annualized rate. This survey was conducted in 36 Chinese cities, so it may not reflect the recent weakening in Beijing and Shanghai sales.

Jing Ulrich, managing director and chairman, China equities and commodities at JP Morgan, notes that in the first quarter China’s year-on-year gross domestic product growth rebounded to 11.9%.

Impressively, corporate earnings were up 63.5% from a year earlier. But she says investors are finding little cause for optimism amid the government’s gradual tightening of monetary policy and exit from last year’s supportive real estate policies. Property construction accounts for 22% of China’s fixed investments and supports demand in many downstream industries.

But after falling 20 per cent from November’s high, stock valuations look undemanding. The forward price-to-earnings ratio for the Shanghai Composite is 15.2x, compared to a three-year average of 22.9x.

As the Chinese mandarins continue to rein in property markets and lending, it seems logical that liquidity in China at some point will return to the Shanghai market. Negative real interest savings accounts are not an attractive option.

Further tightening in China may be put off given the slower growth numbers and the weaker euro that is down 14% against the yuan, and this is hitting Chinese exporters hard.

Morgan Stanley China A Shares Fund (NYSE: CAF) is the only A share fund open to American investors. It trades at a 1% discount to [net asset value,] and I like the sector distribution, with 28% to consumer goods and services, 26% to financials, and 18% to basic materials. The JF China Region Fund (NYSE: JFC) is another option, and its 16% discount to NAV is tempting but its 40% exposure to financials makes me pause. In addition, JFC includes only H shares and 48% of its exposure is through Taiwan and Hong Kong.

Of course, calling the bottom of the Shanghai market is tricky, so I suggest an out-of-the-money put on iShares FTSE Xinhua 25 index (NYSEArca: FXI) as “China portfolio insurance.”

If we are anywhere close to the bottom on Shanghai, the cost of this protection will be minimal looking forward.

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