China: Bubble or Bull Market?

By William Patalon III
Managing Editor
Money Morning/The Money Map Report

With stock prices in China continuing to soar, I decided to sit down this week with our resident Asia expert, Keith Fitz-Gerald, to talk about the promises and perils of the China market.

Given some of the landmark calls Keith has made - the historic rise in crude oil prices and the credit crisis that roiled the world financial markets - his thoughts on Asia and mainland China are exclusive for Money Morning readers.

Here are some of the highlights of our interview:

WP: Let's talk China. There's been an unprecedented increase in stock prices. As a well-known contrarian investor, that kind of price action always leaves me worried. And, yet, I'm also a big believer in China. What's the real story here? Is it a bubble or a bull market?

KF: That's an excellent question... There's no doubt we're in the late stages of a historic bull market, but we're still early when it comes to calling it a bubble.

WP: That's an interesting way of qualifying what we're seeing. Could you be more specific?

KF: You know as well as anyone that a bubble usually manifests itself through obscene, and unsustainable, valuations. Now, there's no question that the valuations on Chinese stocks are very high right now - in fact, they're among the highest in the world - but everything is relative: They're not yet obscene when compared to the growth that's taking place there. For instance, we're seeing annualized EPS [earnings per share] growth of 70% or better in mainland China, and yet P/E ratios are still being compressed. That suggests that prices still have some additional upside before catching up.

Having said that, valuations will become obscene in advance of a meaningful correction, so that's obviously something to watch out for.

WP: So we could actually still see some additional upside from here?

KF: Yes. Based on how speculative "bubbles" form, and factoring in the remaining pent-up demand from Chinese investors who really want to be part of what's happening in their own country right now, another 30% to 50% to the upside wouldn't be out of the question in my mind. I also like the fact that so many people are becoming pessimistic in the face of rising prices and increasing economic strength. As you know, that so-called  "Wall of Worry" is actually very bullish from an investing standpoint. Of course, it won't be a straight ride up, and it's important that investors understand that.

WP: Talk to me about that for a minute. You're very well-known for having called the China market corrections of last year, and advised your subscribers a mere four days before the China stock market dropped 9% overnight. Do you see a similar correction in the near future?

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KF: From a technical perspective, China corrects or recoils about every seven to nine months, which puts us on course for a pullback in November, if present patterns hold.

But, realistically, a pullback could come at any time. That's why I think investors should carefully protect their holdings using trailing stops - especially in cases where they're sitting on large profits. More-experienced investors could achieve the same objective by using options.

WP: For investors who haven't yet made a move on China, is it too late to do so, now?

KF: Absolutely not. In some respects, the rocket-like trajectory we've seen in the past 12 months is exactly what's going to lure more folks to the party. What's more, what we're seeing in China now is really the first stage of a global 'decoupling' from the U.S. economy that will continue for the next several decades. As part of that decoupling process, investors who get into the game early - and by early, I mean now - will realize some truly garish profits before this is done.

WP: By 'decoupling,' you're referring to the process where one economic superpower essentially leapfrogs another?

KF: That's essentially it. The U.S. market won't be essential to the growth of the world economy as it is now. If it slumps, it won't necessarily take the global economy down with it.

WP: Having the advantage of knowing your investment strategies quite well, I know that you always balance risk and return … so many investors - even pros that I've written about or interviewed through the years, focus so much on returns (profits), that they forget about risk. But you never lose sight of that.

So what do you recommend?

KF: Three things.

  • First, this late in the game you want to be thinking about companies that will profit "because of" China, as opposed to just searching for stocks of companies that are 'in" China. The easy money has already been made. In other words, you want to put new money to work where it's most certain to play out "because of" China's growth, rather than focusing blindly on companies that will profit because they are "in" the Chinese market. This helps keep the upside wide open, but as you've noted plays the crucial role of limiting downside risk - which is something 99% of investors are forgetting in their rush to "get rich" from China.
  • Second, consider indirect exposure through global companies doing business with raw materials, energy, shipping and mainline consumer brands that are really in their infancy in China.
  • Third, wherever possible, make you're your money is in line with long-term fundamentals trends cater to Chinese consumers' needs. As you know, Bill, from the time you spent as a business journalist reporting from Shanghai and Beijing, some of this can actually be accomplished by investing in U.S. companies such as Yum! Brands Inc. (YUM), PepsiCo Inc. (PEP), McDonald's Corp. (MCD), and MGM Mirage (MGM). We've written about many of these companies right here in stories in Money Morning. Others will require investments in well-researched China-based firms like those I write about in The New China Trader, which is our VIP trading service. The bottom line, though, is that it will take the wallets and rising standard of living of China's consumers that will make all of this happen.


WP: As always, Keith, you've provided some very interesting and intriguing insights. And, as you note, we'll continue writing about these opportunities here in Money Morning and in The New China Trader.

KF: My pleasure!

Contributing Editor Keith Fitz-Gerald, a brand-new addition to The Money Morning team, is one of the world's foremost experts on the Asian markets, especially China and Japan. A professional trader who works with qualified investors and institutions, Fitz-Gerald likes to do “boots-on-the-ground” research. In doing so, he’s established a deep intelligence network throughout Asia. He and his family split their time between Oregon, Austria and Japan. He writes regularly for Money Morning, our daily global news service. He’s also the new editor of The New China Trader, one of our VIP Trading Services. To subscribe to Money Morning, our popular and fast-growing free global investing news service, please click here. If you sign up for Money Morning, you will receive our free 6,000-word research report, ‘The Three Best Investments in Asia Today.’

About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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