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Is China's stock bear market an opportunity, or a trap?

June 30, 2010 |  2:00 am

The world’s two worst-performing stock markets in 2010 have that in common -- and virtually nothing else.

China’s Shanghai composite stock index was down 26% year-to-date through Tuesday, which among the world’s major markets was second only to financially destitute Greece's 35% market plunge.

Now, Bloomberg News takes an analytical look at Chinese shares and declares that it’s time to buy:

The Shanghai composite index’s plunge this year . . . sent its price-earnings ratio to 18, the lowest level versus the MSCI Emerging Markets index in a decade. The largest owners of yuan-denominated stocks have turned net buyers for the first time since equities bottomed in 2008, while international investors are paying the biggest premium in 21 months to bet on a rally in funds that hold China’s yuan-denominated or A shares, data compiled by Macquarie Group Ltd. and Bloomberg show.

Market bulls believe that the Chinese economy will continue to expand and, with it, corporate earnings. They think the government’s recent decision to allow the yuan currency to appreciate will be a net positive over time by giving Chinese companies and consumers more purchasing power (although the shift clearly will squeeze some exporters).

Chinaflag And they aren’t put off by Beijing’s moves this year to try to slow the economy, and specifically, real estate speculation -- even if the slowdown may be succeeding too well for some investors’ comfort.

Michael Pettis, a finance professor at Peking University who writes the China Financial Markets blog, suggests that the best reason to buy beaten-down Chinese shares is if you figure, as he does, that the central government is about to step in to prop up the market.

In a blog post earlier this month Pettis wrote about the highly speculative nature of Chinese stocks -- not a new thought, but he lays it out in good detail:

China does not have a well-balanced investor base. There are almost no arbitrage or relative value traders because they require low transaction costs and the legal ability to short securities, which has only been permitted on the mainland recently and is severely restricted. There are also very few value investors. The vast majority of investors in China tend to be speculators. This makes the Chinese capital markets fairly volatile and very poor at rewarding companies for decisions that add economic value over the medium or long term.

Even if you just can’t stand the thought of ignoring a market that’s now down 30% from its 52-week high (as Shanghai is), there is another challenge: You have plenty of U.S.-listed choices among conventional mutual funds and exchange-traded mutual funds that own Chinese stocks, but depending on the shares they hold you may be surprised at how little they’re down this year.

In other words, there may be a vicious bear market going on in Shanghai, but not necessarily in the Chinese stocks you might want to buy.

One of the best-known China-market ETFs, the $7.8-billion-asset iShares FTSE/Xinhua China 25 index fund (ticker symbol: FXI), is off just 7% this year, or about one-quarter of the decline of the Shanghai composite index, and not much worse than the 6.6% drop in the U.S. Standard & Poor's 500 index. The fund owns shares of the biggest Chinese companies, most of which primarily trade in Hong Kong.

But don't assume that that means the FXI fund can't be more volatile: It managed to crash 73% from its 2007 high to its 2008 low amid the global financial crisis.

For investors (or just speculators) who suspect there's opportunity brewing in China's markets, this Minyanville blog post from March is a good starting place for researching China-related ETFs.

If, on the other hand, you're looking for someone to talk you out of risking any money in China, Marc FaberJim Chanos and Andy Xie are happy to oblige.

-- Tom Petruno