Chinese Stocks Still Not a Buy

To say the year so far has been a wild one for Chinese stocks would be an understatement.

After rallying more than 50% between the end of 2014 and mid-June, Chinese stocks finally had the rug got pulled out from underneath them. The Shanghai Composite Index has fallen nearly 19% over the course of the past two weeks against a backdrop of numerous red flags regarding China’s weakening economy.

Chinese stocks, Shanghai Composite IndexAnd it’s not as if U.S. investors have fared any better than Chinese investors since the June 12 peak. ETFs and ADRs that reflect Chinese stocks have been just as tough to own.

The iShares FTSE/Xinhua China 25 Index ETF (FXI) as well as the Claymore/AlphaShares China Small Cap ETF (HAO), for instance, have both been in steep selloffs, confirming the weakness has impacted every part of the Chinese market.

The big question now is … what next?

How Did We Get Here?

To really get a firm grip on where Chinese stocks are going, one has to figure out how they got to where they are now. Specifically, one needs to determine why the Shanghai Composite Index reversed a downtrend last July, and then really turned up the heat beginning in November of last year.

Theories are numerous, but most likely the prod was a combination of several factors… including the reality that too many new (and naive) Chinese investors chose to see the glass as half full rather than half empty.

Broadly speaking, China’s economic growth has been slowing for some time. That deceleration, in addition to growing consumer debt on top of sweeping governmental reforms, all came to a head in the middle of last year. It was a troubling enough situation that by November the nation’s government lowered interest rates in an effort to re-accelerate China’s growth.

At the same time, the relatively recent advent of broadband and even more recent advent of mobile broadband connectivity has made the stock market accessible to Chinese citizens who have never had access to the equity market before.

With Chinese brokers — and even all-purpose lenders — more than willing to lend to investors who were eager to borrow at low interest rates, visions of wild profits obscured to these newcomers that the state’s economy was firing on all cylinders. In less than a year, Chinese stocks soared an average of more than 150%.

Yes, it’s not unlike what the United States saw happen in the late ’90s. Just like what the U.S. went through beginning in March of 2000, Chinese investors finally realized a couple of weeks ago that Chinese stocks simply aren’t, as a group, worth what investors were paying for them … not even close.

In other words, the hype-bubble got popped.

Is It Over Yet?

As for whether or not Chinese stocks have finally hit bottom and are ready to recover, the consensus is that China’s stock market has yet to see their worst. The same goes for U.S. counterparts like FXI or HAO.

China’s stock market was driven higher by new traders chasing gains, fueled by cheap loans, and the erroneous assumption that the state’s government would never do anything to stop the proverbial gravy train. For perspective, margin debt in China has reached 3.4% of Chinese stocks’ total market cap — an increase of almost 130% just this year.

That amount of leverage can have a huge impact. And that impact is magnified when stocks are falling, as margin calls accelerate the rate of selling.

Perhaps just as suggestive of a bubble is the fact that 4,000 hedge funds and private equity firms were opened in China between March and May. That was a 50% increase in the number of such funds, while the amount of assets under their care ballooned more than five-fold.

These pools are forced to invest money somewhere, somehow, so there’s little doubt the chasing of gains has fueled the very rally stock-pickers are working to capture. But sooner or later, these (often very leveraged) funds will have to sell to book profits. The question is, who are they going to sell to?

Put it all together, and there’s still a ton of unwinding to work through for China’s equity market.

Bottom Line for Chinese Stocks

To the extent it matters, the Shenzhen exchange’s stocks are now valued at an average trailing P/E of 52.

Were those stocks, and other Chinese stocks for that matter, in a position to grow into that valuation or even grow earnings to pull that valuation metric lower, the country’s equity market might be palatable as is. But neither scenario is particularly plausible in the near term.

The fact is, there’s little evidence those stimulative efforts have spurred more activity that would increase corporate earnings. The HSBC/Markit purchasing managers index for June, as an example, was the fourth month in a row the measure of Chinese factory activity fell. This time, the slump carried it to 49.1

Investment research outfit Barclays plainly said on the matter, “Overall, in our view, there are not yet convincing signs of near-term stabilization in the economy. We believe risks to the outlook remain to the downside, with the property market correction and government-led infrastructure projects holding the key for the outlook.”

Underscoring this idea is news that on Saturday — just two days ago — state officials announced another interest rate cut. That marks the fourth interest rate cut since November.

In other words, even with the recent implosion, investors would be hard-pressed to justify stepping into Chinese stocks at their current value against the nation’s current economic backdrop. Somehow, we’re still miles away from the “can’t get any worse” scenario.

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

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