Time for a Rebound in China

On Aug. 14, U.K. Fool Stuart Watson -- from our sister site, fool.co.uk -- provided an interesting take on Chinese stocks, originally entitled "Time to Top Up in China." We thought you'd like to read it. The article has been updated and Americanized by Todd Wenning.

We're getting used to a lot of fakes at these Olympics. So far we've had fake fireworks, fake singers, and even fake crowds. With the Chinese stock market down some 60% since it peaked last year, people are starting to sense that the Chinese economic miracle is equally suspect.

Indeed, the recent performance of the Chinese stock market is a good reminder of just how volatile emerging markets can be. The Shanghai Composite index, one of the main measures of Chinese shares, fell by 50% from late 2001 to late 2005. Then, in the following two years, it gained an astonishing 500% before starting its current slide.

Why are emerging markets so volatile? Much of the problem stems from hot money from the West looking for the next big thing. And they don't come any bigger than China.

You might think the size of the Chinese market would afford some protection from the flow of fickle funds. Four of the 20 largest public companies are Chinese, and only the U.S. and Japanese stock markets are worth more.

But many firms, such as PetroChina (NYSE: PTR) and China Mobile (NYSE: CHL), are still majority-owned by the Chinese government, so lots of Western money has been chasing relatively few available shares, squeezing prices upwards as a result. As we've seen in recent months, the process works in reverse as well. 

Scary price-to-earnings ratios
As another Foolish writer noted in an article here, the price-to-earnings (P/E) ratio for the Chinese market was looking extremely lofty last year, at far more than 40. These turned out to be well-timed warnings. The subsequent fall has taken the Chinese market to a point only marginally above where it was back in 2001.

Other emerging markets have been struggling, too, of course. Brazil, Russia and India -- the three nations often lumped in with China as new economic superpowers -- have fared much better, however. Although all their stock markets have declined recently, Brazil and India are at roughly the same level they were at 12 months ago, and Russia is only some 10% lower.

China's economy
China's rapid growth is slowing a little, although it still tops 10% a year. The Chinese government has been raising interest rates to bring down inflation, while lower demand from the U.S. for its manufactured goods is also having an effect. The brakes seem to be working; Chinese consumer inflation has decreased by a couple of percentage points this year, in contrast to the experience of most other countries.

Questions are increasingly being asked about the quality of China's growth, however, and the robustness of its lending practices have been criticized. It will become increasingly dependent on food and raw material imports in the coming years, too. Despite all this, the country is expected to take over from the U.S. as the world's largest manufacturer next year with a 17% share. Back in 1990, it accounted for just 3%.

Growing pains?
The key question for investors is whether the current problems are just normal growing pains, or owe to deeper structural faults that will prevent China being the economic superpower most people predict. Not having been anywhere near China, and typing this piece in drizzly, windswept Hertfordshire, I find this a difficult call to make! I suspect it's the former, however.

The p/e ratio for the Chinese market has fallen back from its heady heights to the high teens. This isn't bargain territory, but it's not overly expensive, either.

Investing is a long-term game, but in my view, a bet on the growth of a country like China should be seen as a 10-to-20-year play. Given that sort of timeframe, now looks like a reasonable entry point, although dripping money into the market on a regular basis will be a better strategy for most people. It's certainly easier on the investing nerves!

Top-rated Chinese stocks on Motley Fool CAPS:

Source: Motley Fool CAPS, as of Aug. 14, 2008.