The bubble in Chinese stocks is bursting and there is nowhere to go but down. That is the common refrain echoed throughout the financial media in recent weeks, ever since China shares began their sharp decline after peaking in early June.
But is the outlook for China really all that bearish? And if so, is there a way to profit from the stock market plunge?
P/E Ratio Not High
There has been no shortage of analysts coming out with bearish calls on Chinese stocks this year. That's certainly understandable in light of the massive run-up in equity prices prior to June, which propelled the benchmark Shanghai Composite Index to a year-to-date gain of 60 percent at one point. From its lows in 2014, the index was up an even more massive 160 percent through June 12.
Shanghai Stock Exchange Composite Index
While the big increase in prices in such a short period of time doesn't necessarily mean stocks are in a bubble, it's a cause for concern and further analysis.
At the heart of any bubble argument is valuation; the Chinese stock market would have to be massively overvalued based on traditional investment metrics to be considered a bubble. In that regard, the bubble argument isn't cut and dried.
Based on data from Bloomberg, the Shanghai Composite has a price/earnings ratio of about 18, down from 26 at the June highs. Ironically, that's the same as the P/E ratio for the most popular United States stock index, the S&P 500, and not many people are saying U.S. stocks are in a bubble.
‘We Are Still Positive’
That's why some analysts, like Kinger Lau of Goldman Sachs, are actually bullish on China stocks. "Re-rating is not over for China's stock market," Lau told Bloomberg. "We are still positive."
Lau emphasized that Chinese stocks are much cheaper than they were during the last buying frenzy in 2007, when the Shanghai Composite traded at more than 40 times earnings.
Furthermore, while it's been unsuccessful thus far, the Chinese government has taken an active role in trying to stem the decline in stocks, going as far as to ban IPOs and force state-run entities to buy up shares.
That could ultimately turn the tide; indeed, it's often been a losing proposition to bet against the Chinese government during the past few decades.
Still, even though the main Shanghai Composite Index doesn't look particularly overvalued at this point, there's nothing to say it can't get cheaper. After all, the index's P/E ratio was less than 10 just a year ago.
Moreover, some analysts say that excluding China's cheap financial giants, the market looks much more bubbly. In fact, the CSI 500 Small Cap Index, which excludes those firms, is trading at a much loftier P/E ratio of 48 currently, down from an eye-popping 83 in June.
CSI 500 Small Cap Index P/E
It's no wonder then that small-caps, the segment of the market that ran up the most dramatically during the past year (threefold in the one-year period through June 12), are getting hit the hardest.
The Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS | D-73) is the worst-performing China exchange-traded fund. with a loss of 52 percent in less than a month. The ETF has essentially given back all of its gains for the year, but is still up 37 percent from a year ago.
For investors looking for bubbles in China, the small-cap arena is where to look.
Shorting The Market
That said, is there still a case to be made to short China stocks? To be sure, the Chinese economy continues to face head winds. Economic growth is projected to be around 7 percent this year, which would be the slowest pace in more than two decades. Additionally, there are all sorts of concerns about the health of China's real estate market and the "shadow banking" sector.
On a pure valuation basis, small-cap Chinese stocks still look expensive, while large-caps look more reasonably priced. In any case, in the near term, China stocks are likely to move together directionally regardless of individual valuations, as momentum trading rules the day.
If stocks decline to just where they were last year, that could entail losses of more than 30 to 40 percent for a small-cap ETF like ASHS or its larger-cap counterpart, the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (ASHR | C-60).
Outright shorting of those ETFs may be a possibility if shares are available to borrow. However, some traders may find it easier to buy one of the handful of inverse China products that are out there.
The newest of the lot at less than one month old is the Direxion Daily CSI 300 China A Share Bear 1X Shares (CHAD). It is essentially the inverse of the aforementioned ASHR. Since debuting on June 17, CHAD has surged more than 50 percent, benefiting from the bloodbath in Chinese stocks in the period.
CHAD is the only inverse fund that provides exposure to China A-shares, which are mainland China stocks traded on the Shanghai or Shenzhen exchanges, and are at the heart of the recent market volatility.
The other 1x-inverse fund on the market, the ProShares Short FTSE China 50 (YXI) provides bearish exposure to large Chinese stocks listed in Hong Kong. While YXI has performed well recently, rising 20 percent in the past month, most of that gain came in the last three days, illustrating the difference in performance between A-shares and H-shares.
In addition to the basic inverse exposure provided by CHAD and YXI, there are two leveraged inverse products available for more daring speculators.
The ProShares UltraShort FTSE China 50 (FXP) offers 2x-leveraged-inverse exposure to the largest stocks on the Hong Kong Stock Exchange, while the Direxion Daily FTSE China Bear 3x (YANG) offers 3x-leveraged-inverse exposure to the same FTSE China 50 Index.
Over the past month, FXP is up about 53 percent, while YANG has spiked 86 percent.
1-Month Performance For CHAD, YXI, FXP, YANG
It's important to remember that all of the inverse and leveraged funds are rebalanced daily and are likely to experience performance drag over time due to volatility and compounding.
The Bottom Line
At the end of the day, where Chinese stocks go from here may have more to do with investor confidence and momentum than any fundamentals related to corporate earnings or the economy.
Playing the swings in the notoriously volatile Chinese stock market is a risky endeavor, but one that may be rewarding for those with good timing.