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How to Play the Bubble in Chinese Stocks

Investors who can tolerate the risk have a real opportunity here

Here in the U.S., investors and market watchers continue to debate whether we’re entering a bubble. This talk is fueled by the bond market and the venture-backed technology sector where it seems every day there is a new unicorn-billion-dollar company that is being championed.

chinese-stocks-chinese-bubbleHowever, there is another area that is getting overheated: Chinese stocks.

According to a report from CNN Money, the overall Chinese market is worth a staggering $10 trillion, including the Shanghai Stock Exchange and the Shenzhen Stock Exchange.

True, a stock bubble can last for a while — as seen with the dot-com surge in the 1990s — which makes it pretty tough to find the top. Yet there are some big-time signs that Chinese stocks are really at unstainable levels — and could be poised for an imminent crash.

Reasons the Chinese Bubble Is About to Pop

#1 — Weakening Chinese Economy

In Q1, GDP grew at 7%. While that would be a great number for the U.S., it’s actually pretty awful for China — the slowest growth rate since 2009. After all, the government has been aggressively pumping up monetary policy – with three rate drops in 2015 – and has increased infrastructure spending.

But the fact is that there are some major headwinds, such as the unwinding of the real estate bubble. In the latest quarter, housing prices plunged by 9.1%. There was also deceleration in industrial production, retail sales and exports.

Other historical bubbles — such as the U.S. real estate implosion of 2007 — are often marked by weakening economic activity. That weakness results in much lower earnings as well as increased fear for investors.

#2 — Stocks Going Parabolic

At the latter stages of a stock bubble, there is usually a massive surge in stock prices. And yes, Chinese stocks have been in this phase for 2015.

Consider that the Shanghai Composite is up 38%, and Shenzhen Composite has clocked a return of 94%. On a combined basis, Chinese stocks are trading at a nose-bleed 84 times forward earnings — which double the valuation of Chinese stocks in 2007. By comparison, Facebook (FB) has a multiple of 31 and Twitter (TWTR) is considered very expensive at 54.

The total market value of Chinese stocks is roughly 1.1 times the GDP. That number is approaching the level that Chinese stocks reached during their 2007 peak.

#3 — Retail Mania

Before the 1929 crash, Joseph P. Kennedy, Sr., noted: “I knew it was time to sell when my shoeshine boy gave me a stock tip.”

This is all part of the “greater fool theory.” That is, when inexperienced investors jump into the stock market, it’s usually a sign that a bubble is forming.

As for China, there has been a frenzy of activity from retail investors. While new brokerage accounts came to 200,000 per a week from 2010 to 2014, they have since gone into hyperdrive. Early in June, there were 4.5 million opened! Up to 90% of daily trading volume comes from retail investors.

Debt has also been a factor. For example, margin is now at an annualized 6% of GDP, which is double the level at the beginning of the year. Keep in mind that the Chinese government has introduced programs to make it easier for investors to borrow larger sums.

How to Play a Chinese Bubble

Short selling is the process of making money when the value of a stock falls. This is done by borrowing the shares and selling them. Then, you later buy them back — hopefully after the stock falls. With Chinese stocks, you can short an exchange-traded fund (ETF) that tracks a basket of stocks.

Admittedly, short selling can be a risky endeavor. If the value of the ETF increases substantially, you will get a “margin call” from your broker, which means you will have to put up more money for the trade. If you don’t pay up, your broker will unwind your position.

In fact, your losses can ultimately be higher than the initial value of the stock price (if the ETF more than doubles). At the same time, the gains are capped at 100% — that is, if the value of the stock plunges to zero (which, in the case of these ETFs, is extremely unlikely).

So it’s a risky play, but a worthwhile one if done smartly. Here are some ETFs to consider shorting for the Chinese bubble:

  • db X-trackers Harvest CSI 300 China A-Shares Fund (ASHR): The ASHR replicates the CSI 300 Index, which includes 300 stocks listed on the Shenzen or Shanghai Stock exchanges. While this index is focused on large caps, there is a heavy concentration of financials. Such companies could certainly come under lots of pressure if there is a crash because of the issues of liquidity and debt exposure.
  • China Small Cap ETF (HAO): The HAO tracks the AlphaShares China Small Cap Index, which includes companies that have floats that range from $200 million to $1.5 billion. No doubt, these are the types of stocks that have seen the most frothiness and are likely to be very vulnerable if there is a crash.
  • iShares China Large-Cap ETF (FXI): The China Large-Cap ETF tracks the FTSE China 25 Index, which include the largest companies in China. Admittedly, the FXI probably isn’t the most ideal choice for shorting, as these kinds of Chinese stocks are likely to be more stable. But if you’re extremely confident that the bubble will hit in the near future, the FXI is a legitimate option for shorting.

Of course, some investors avoid short selling because of the risks and requirements, such as the need to have a margin account.

What to do? Well, one option is to look at inverse ETFs, which track indices in the opposite direction. For a basic inverse ETF, the value of the fund will increase 1% for every 1% drop in the underlying index.

There are also leveraged inverse ETFs, which amplify those performances. For instance, a 2X inverse ETF will increase 2% for every 1% drop. There are only a small number of inverse ETFs available, however, such as ProShares Short FTSE China 50 (YXI). This is a basic inverse ETF that tracks the FTSE China 50 Index, which focuses on large caps.

But for leveraged ETFs like this, the overall risk can be brutal. Small moves in the wrong direction can result in big losses for investors, and such funds should only be used by knowledgeable traders with very high risk tolerance.

Bottom Line for Chinese Stocks

As famed billionaire investor George Soros once said: “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.”

There are certainly clear signs that Chinese stocks look like they are in bubble territory. Valuations are excessive, the recent moves have been parabolic and retail interest is at fever pitch. The only question is where you’ll be when the bubble pops.

Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO StrategiesAll About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.

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