Just when you think Chinese stocks have put the worst behind them, the bear growls at them again.
On Monday, the Shanghai Composite Index fell 0.8%, snapping a strong, two-day win streak that not only pushed Chinese stocks more than 13% up and off last week’s multi-month lows, but had suggested Chinese markets were on the road to recovery.
All told, the Shanghai Composite Index lost more than 12% of its value in August, after losing 14% in July.
The back-to-back drubbings clearly put Chinese markets into bear-market territory, but perhaps more troubling than that, the sheer size of the pullback has inspired chatter that more pain is on the way.
For those investors who understand that the way things are today isn’t necessarily the way they’ll be tomorrow, however, this steep pullback may actually make Chinese stocks a buy.
The Shanghai Composite Index: There and Back Again
The sordid saga of Shanghai’s stocks has also been well documented.
The heroic move that started in the middle of last year carried Chinese stocks more than 100% higher between June of last year and June of this year, indirectly encouraged by a government that paid generous lip service to the data that supported the rally, and a government that chose to look the other way in terms of how it was skyrocketing.
Then in June, reality struck.
Although Chinese stocks had been soaring, earnings weren’t. With the bubble exposed, enough traders started to lock in profits to jump start a chain reaction selloff, largely fed by margin calls. It became self-fueling epidemic that didn’t run out of gas until last week when the Shanghai Composite made a hard landing at $2850 and then bouncing sharply to a close of $3232.
For some onlookers — expert and amateur alike — the speed and scope of the selloff has prompted predictions of more market weakness, and contractions in growth outlooks.
Bank of America’s China equity strategist David Cui is one of those expert pessimists. He recently noted:
“As soon as people sense the government is withdrawing from direct intervention, there will be lots of investors starting to dump stocks again.”
Ultimately, he felt the Shanghai Composite Index wouldn’t be attractive again until it was 35% below recent levels.
Goldman Sachs, meanwhile, also saw fit to dial back its gross domestic product growth outlook for China. Now the investment bank believes the country will see economic growth of 6.4% next year, and 6.1% in 2017. Goldman had been calling for 6.7% and 6.5%, respectively.
Based on the status quo, the dire outlooks make sense. On the other hand, the current status quo may be on the verge of coming to an end, and even the experts can forget that tough situations don’t last forever. Translation: It may be time to go fishing for undervalued Chinese stocks. In fact, there are three distinct clues that say it’s time to start taking a serious look at these beaten-down names.
Just to stave off confusion, nobody really knows when and where the bottom for Chinese stocks will happen. But there are some hints that we may already be near the low point if we’re not already there.
Three of these hints are worth a closer look.
Pessimism on Chinese stocks Is Peaking: It’s counterintuitive, but that’s the point. It’s called contrarianism; which is simply a fancy was of saying the best time to buy into a stock or a market is when most of the crowd is absolutely certain it can only go lower. By that point, most of any would-be selling has already been done. And how do we know fear regarding Chinese markets has peaked? In the past six months, the price of put options on the China 50 Index have been relatively higher than call options. Like the United States’ Volatility Index (VIX) or put-to-call ratio, it’s a clue that the market has none of the proverbial blood left to give.
Chinese Stocks Are Cheap: The average trailing price-to-earnings ratio for stocks listed on the Shanghai Stock Exchange now stands at 15.6. Even its lower-tier B-shares are valued at a trailing P/E of 17.1. For perspective, the United States’ S&P 500 is currently valued at a trailing P/E of 19.9 while the Nasdaq 100 Index is valued at a trailing twelve-month earnings multiple of 22.3. If the valuation of American stocks is justifiably frothy with merely mediocre economic growth, surely global investors will see Chinese stocks as undervalued with that nation’s still-impressive economic growth rate predictions of greater than 6.0%. And you can find plenty of the nation’s best stocks in ETFs such as the iShares MSCI Hong Kong ETF (EWH), which sports an expense ratio of 0.48%.
Everything’s Poised to Improve From Here: Last but not least, the fact that the Shanghai Composite Index only fell 0.8% on Monday, when the Chinese government announced it would not be buying stock to support its market, is a tacit message that Chinese stocks as a whole have pretty much decoupled themselves with the government’s rhetoric and policy. That’s ultimately a good thing, as traders and investors alike are finally starting to value Chinese markets based on plausible economic and earnings outlooks rather than premises and promises. With that as the backdrop, the fact that Goldman Sachs recently suggested Chinese stocks are a buy based on the potential of future stimulus, and the fact that the worst-case scenario is already factored in, speaks volumes about the opportunity few others see right now in the smoke of the recent decimation of Chinese markets.
Bottom Line for Chinese Stocks
This isn’t to suggest Chinese stocks are going to make a beeline straight for record highs. But, it is to suggest the worst is winding down for Chinese stocks, and investors would be wise to start looking at buying them while the last of the stragglers are selling.
The pendulum swings in both directions.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
