Biggest Economy or Not, the U.S. Stock Market Is Still Your Best Bet

On the surface, it looks like the Chinese stock market  has become the no-brainer place for U.S. investors to seek growth.

U.S. stock marketWith the U.S. stock market increasingly overvalued and new data coming out just this week suggesting China has replaced the United States as the owner of the world’s biggest economy, why not invest where the growth is?

With the Chinese stock market officially opened up to foreign investors in November, there’s no good reason not to tap into this obvious growth arena.

Before traders abandon the U.S. stock market for what seems like greener pastures, however, they may want to take a closer look at the reality of the opportunity. Not all is as it seems.

Chinese Economy Surpasses U.S. Economy

While some had previously claimed China surpassed the U.S. economy in terms of size, this week’s pronouncement from the International Monetary Fund solidified the claim. The IMF projects that China will produce $17.6 trillion worth of goods and services this year, versus only $17.4 trillion for the United States. Less than two decades ago, the U.S. was three times as productive as China.

That pace of growth is understandably compelling to investors who have grown weary of the U.S. stock market over the past 15 years. While the U.S. market has roared at different times since 2000, the S&P 500 right now is only 33% above its 2000 peak — not great for that length of time.

Although the Shanghai Index hasn’t performed much better than that for the same timeframe, it feels healthier going forward just because the nation’s leaders have made a deliberate effort in recent years to empower its consumers and engage in more foreign trade.  However…

The U.S. Stock Market Still Has Two Key Advantages

So why would an American investor want to skip this opportunity to capture good-looking growth and geographically diversity? Two reasons:

#1 — U.S. investors still have little to no regulatory protection with Chinese stocks.

It’s a largely unrecognized reality (or largely ignored, or both), but many of the U.S. market’s most-loved Chinese stocks including Alibaba (BABA) aren’t actually shares of the company. They’re variable interest entities, or VIEs for short, that represent actual shares held by a third party. It’s a problem for American investors because they don’t actually hold any voting right with those shares the way they normally would with a U.S.-based company.

Planning on buying Chinese stocks directly through a Hong-Kong based broker to circumvent that risk? It’s possible to do so as of last month, but bear in mind the SEC has no jurisdiction in China, and China’s market regulators have never been sympathetic to American investors who’ve had reason to complain. China doesn’t even allow U.S. officials to look at the audits performed by Chinese accounting firms, all in the name protecting state secrets.

Indeed, even the legality of VIEs has been treated like a gray area by the nation’s courts and regulators.

Though it would be an extremely unlikely outcome, some have noted China’s government could arbitrarily delegalize all VIE structures and pull the rug out from underneath their holders in cases where a direct holding wasn’t held.

#2 — The growth and investment opportunities in China are more limited than you think.

Interestingly, while the rest of the worlds appears to be beating down the doors of the Chinese stock market in an effort to grab a piece of the growth story, a suspiciously high amount of Chinese money is still desperate to invest in the U.S. stock market. If the opportunities were so great at home, wouldn’t that capital simply be invested there?

The evidence: In 2013, Chinese investors poured $14 billion worth of investment dollars into the U.S. stock market and U.S. real estate — well up from 2000’s total of $58 million. The rate of outbound investment dollars from China has grown an average of 35% per year between 2005 and 2012.

Though 2014’s year-to-date inflow of Chinese investment dollars isn’t as impressive, it’s unlikely the U.S. stock market and U.S. real estate opportunities became suddenly unlovable to China’s investors. All told, Chinese investments sent outside that country are poised to reach $120 billion this year, up from $108 billion last year. That figure could reach $172 billion by 2017.

It doesn’t inspire confidence from the people who are more familiar with the Chinese stock market.

Bottom Line for Traders Interested in Chinese Stocks

As the saying goes, the grass always looks greener on the other side.

It’s difficult enough to get good information about U.S. companies with stocks trading on U.S. exchanges, even though the system is designed to foster transparency and  facilitate protection for U.S. investors who feel they’ve been wronged.

The transparency of Chinese stocks is considerably weaker, and it’s a problem exacerbated by thousands of miles, a different language, a different mindset, and different time zone. There’s also no guaranteed path of recourse for foreign investors who’ve been wronged.

Throw in the fact that plenty of Chinese investors continue to make a point of investing somewhere besides their own country, and the argument to simply stick with the U.S. stock market you already know — warts and all — makes a lot of sense.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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