China Stocks Down, But Not Out

Although China stocks and ETFs like the iShares FTSE/Xinhua China 25 Index ETF (FXI) and the iShares MSCI Hong Kong Index Fund (EWH) didn’t exactly end 2015 on a bullish foot, at least it could be said Chinese stocks managed to keep themselves in position for a breakout.

China Stocks Down, But Not OutNow though — thanks to Monday’s reports indicative of a slowing economy in China — EWH, FXI and a whole slew of other China stocks and ETFs stumbled out of reach of a rekindled rally.

It leaves investors wondering if this particular market ever really worked its way out of the bubble that first formed in early 2014 and reached ridiculous proportions by the middle of 2015.

While the Shanghai Composite Index (the primary barometer of Chinese stocks as a whole) lost a whopping 42% of its value between June and August of last year, here within sight of new lows again, it wouldn’t be unreasonable to assume China stocks are trying to tell us something about the country’s foreseeable economic future.

The Straw That Broke the Camel’s Back

Not a great deal of recent economic news from China has been encouraging. For instance, in June of last year, the country’s 5.3% dip in automobile production was only topped by the 6.1% contraction in automobile purchases. That should have been a particularly alarming red flag as, if anything, China’s soaring stock market up until that time should have spurred enough confidence to keep consumption going.

Moreover, in October, the country’s exports fell for a fourth straight month … a particular problem for an economy that, despite growing consumerism from its own participants, still largely depends on overseas customers.

For whatever reason though, it was the recent report of China’s Purchasing Manager Index (or PMI) that upended Chinese stocks.

Specifically, the unofficial Caixin Purchasing Managers’ Index fell from November’s score of 48.6 to 48.2 in December rather than rising to the expected level of 49.0, while the government’s official manufacturing PMI score fell to 49.7.

Any reading under 50 is considered recessionary for both sets of PMI data, and the fact that China’s Caixin PMI indicator has now fallen for 10 straight months fanned the flames of worry. The Shanghai Composite Index fell more than 6.8% following the news, and may have been able to move even lower had marketwide trading not been halted.

Proverbially calling a spade a spade, ET Now‘s Consulting Editor Mythili Bhusnurmath opined:

“The latest PMI numbers from China are not very significantly lower than what they were the previous months. The panic in markets shows that markets were already nervous…As far as the China is concerned, everybody knew that the Chinese economy was slowing down.”

The same news that drove a selloff of China stocks hit other markets hard too. The UK’s FTSE 100 Index fell more than 2.5%, while the S&P 500 was off more than 2% on fears of the ripple effect of an economic slowdown in China.

Bottom Line for China Stocks

It remains to be seen if Chinese stocks and their corresponding ETFs, like EWH and FXI, are down just temporarily, or if a bigger-picture pullback is underway. From a valuation standpoint, though, the sharp dip is arguably a buying opportunity.

While strong growth has been tough to muster in China for a while, it must be appreciated that slow growth in China is still faster growth than strong growth anywhere else. For perspective, China’s GDP growth was officially 6.9% last year, but even the more plausible unofficial third-party estimates suggest the country’s economy grew at a pace near 4% in 2015.

Granted, that was then and this is now, and the gradual slowdown may not become fully evident until now. As observers are quick to jokingly but truthfully say, however, economists have predicted seven of the past four recessions … an indirect way of saying the worst-case scenario rarely comes to pass.

In the meantime, the average China stock listed on the Shanghai Stock Exchange is valued at a trailing price-to-earnings ratio of 16.4. That’s cheaper than the average U.S. stock right now.

But is it a believable figure?

Maybe, or maybe not. It’s no less believable now than any of the state-driven numbers have been for the past several decades, however, so even if it’s a mirage, it’s a well-supported one that can lead to sizable gains when the rhetoric tide turns in a bullish direction.

That could happen again sooner than later.

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

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