At the end of May, I was telling China stock and ETF investors that the next 5% move in Chinese investments would be up rather than down. Well, during the following week my forecast largely played out as the May swoon ended and China stocks started to gain some momentum in the beginning of June. However, further problems emanating from Europe continue to act as an anchor on the global stock market despite last week marking the broader market’s first weekly move upwards in a month.
So what’s next for China stock investors and BRIC investments (that’s Brazil, Russia, India and China)? Well, with corporate earnings and the global recovery as strong as they are, the recent correction puts us near the bottom of the market’s trading range — rather than the start of a new bear market. That means we are on the cusp of a tremendous buying opportunity in China investments and Asia stocks.
In fact, I believe that the second half of 2010 will bring much more upside to elite Chinese companies. Although the first five months of the year haven’t been the best for BRIC investments and China stocks in particular, there has been one significant contributing factor: At the beginning of the year, the biggest fear plaguing China was a general overheating of their economy and particularly a dangerous, bubble-like situation in their housing market. Beijing responded by engaging in various measures of monetary tightening to keep property speculation from getting out of hand. However, instead of just dampening real estate investing, China’s monetary tightening caused the Chinese stock market to sell off.
But the Chinese government has the power to micromanage the nation’s key economic players in order to adjust for changing conditions. So, instead of hiking interest rates to deal with the housing situation, Chinese officials can take a much more targeted approach to managing any bubble-like conditions. And they are now putting these “micro-surgery” policies in place — such as a trial property tax, tighter mortgage policies and the possibility of suspending new loans in regions where property prices have risen too high.
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As a result, Chinese officials no longer have to engage in wholesale macro-surgery via massive system-wide interest rate hikes, which affect far more than just the Chinese property market. I expect this backing off of any widespread cooling will have a positive impact on our Chinese companies going forward.
In addition, since the Chinese central bank is becoming increasingly dovish during the second half, it is likely that the capitulation selling on May 20th marked an important bottom in Chinese stocks this year.
Because China was the first major economy to recover from the global financial crisis, its central bank was the first to put on the brakes — and after a 110% run up off the lows, its stock market was the first to correct. However, as we saw in the global financial crisis, because Chinese stocks were the first to correct, they will also be the first to recover.
Given the continuing double-digit economic and earnings growth in China, with monetary tightening measures largely out of the way, Chinese stocks should outperform again — like we’ve seen in the past three weeks. After the sharp sell-off in May, these companies are cheap, undervalued and poised to rally big in the second half of the year.
I expect a 40% to 60% rally in elite China stocks in the second half of the year, similar to the one we saw in the second quarter of last year. So China stock investors need to position themselves right now for this upcoming rally. To do so, buy China stocks that are undervalued companies with strong earnings growth in sectors that profit from China’s growing domestic consumption — such as this week’s recommendation in China’s booming travel and tourism industry.
One of the best ways to take advantage of the upcoming rally in Chinese stocks is a major China ETF — the Morgan Stanley China A-Share Fund (CAF).
Here’s why CAF is a great ETF to benefit from the China stock market resurgence: I’m expecting China’s state-owned financial companies to benefit significantly from the upcoming rally. And a significant portion of CAF is financial stocks. Actually, commercial banks make up 25% of the fund, and some of its largest holdings include China Pacific Insurance, China Merchants Bank and China Minsheng Banking Corp.
In addition, as broad-based, closed-end fund CAF invests in some of China’s other important sectors: significantly Energy (the top holding at over 5% is Shanxi Xishan Coal and Electricity Power), Metals & Mining and Machinery. And since CAF invests mainly in A-shares of Chinese companies on the Shanghai and Shenzhen stock exchanges, it will be one of the best ways to play the upcoming China stock rally.
Please note, though, that CAF is likely to be more volatile than a typical China stock. There are two main reasons that make CAF more of a speculative holding: 1) Chinese companies have high valuations right now; and 2) CAF is a closed-end fund, so like other closed-end funds, it is often thinly traded and more volatile than open-end mutual funds.
But despite the risks, I think the profit potential is huge. As Chinese stocks climb higher in, CAF will also be boosted higher and share in the biggest winners across the entire China stock market.
