With US stocks as pricey as they've been in years, here's how to gain exposure to a still-undervalued market.
As the end of the year approaches and the S&P 500 Index ($INX) keeps setting new highs, it seems right to talk about taking some money off the table in U.S. stocks and rebalancing your portfolio.
This is particularly apt advice for traders riding domestic momentum darlings like Tesla (TSLA) and Facebook (FB), which have started to look shaky after big runs to start the year.
Of course, the million dollar question remains where to put any free cash if you sell a partial stake in a big winner. With rates still rock bottom and the Fed showing no signs of letting its foot off the gas, riskier equities have a clear edge over interest-bearing assets.
So if not admittedly frothy U.S. stocks, then where?
I say China.
If you’re worried about overvalued stocks, then China is very appealing. By many measures it’s one of the cheapest stock markets in the world right now.
The Shanghai Composite Index trades for about 1.4 times net assets, a discount of over 40 percent compared with the S&P.
And as Oaktree Capital’s chairman Howard Marks told Bloomberg earlier this month, "The Shanghai Composite’s price-to-book ratio is about half the level it reached in November 2010, while the measure’s price-to-earnings (P/E) multiple is 42 percent lower.”
Separately, at the end of October, estimates by The Financial Times showed Chinese equities trading at a P/E of 7 with a 4.6 percent dividend yield on average.
It’s worth noting that multiple expansion for U.S. stocks is a sign of a bull market to some. Also, there’s no guarantee that Chinese stocks trading for a P/E of 7 have to soar and bring that earnings multiple higher. One way for price-to-earnings calculations to adjust is simply for the E to go down instead of the P to go up.
But it’s worth considering the big differences between the U.S. and China right now in terms of valuation. If you think investors are too bullish on domestic stocks, you may find logic in the argument that investors are also too bearish on China right now.
At the end of October, the U.S. dollar index, a measure of the U.S. currency vs. a basket of foreign peers, fell to its lowest levels since February. And while there has admittedly been a bit of a rally off the bottom, the dollar remains significantly below levels seen this spring and summer.
That weakness in the greenback will create a floor for commodity prices, and help Chinese materials and mining companies as a result of higher prices.
And as a broader measure of demand, consider that China’s manufacturing sector continues to bounce back. In October, China PMI came in at the strongest level in 18 months.
Bigger picture, China gross domestic product expansion accelerated to 7.8 percent in the third quarter, up from 7.5 percent in in the second quarter and bringing growth rates to 7.7 percent for the first nine months of 2013 -- nicely above the 7.5 percent GDP target set in Beijing.
And let’s not forget that signs of a recovery in the U.S. and Europe will undoubtedly have a trickle-down effect. China is the world’s largest trading nation with total exports and imports of almost $4 trillion, so the fact that Europe has exited recession and that American unemployment continues to slowly heal could lend to the long-term recovery hopes of China and its manufacturers that send products here.
There are certainly problems as the nation transitions to a consumer-driven economy, and the growth in China’s manufacturing in recent months may roll back. But for now, the direction is very encouraging.
The risk for many investors, of course, isn’t simply identifying the opportunity in Chinese stocks but how to practically invest in this trend.
The simplest solution for low-risk investors looking for China exposure but not massive weighting in Asia is to go multinational. Whether it’s Yum Brands (YUM) with its huge restaurant presence in China or chip companies like Broadcom (BRCM) and Qualcomm (QCOM) that supply electronics firms here, there are plenty of ways to get exposure in companies you are familiar with -- and more importantly, companies that are easy to trade and must adhere to U.S. securities law in their conduct.
If simply buying a U.S. stock that does business in China isn’t direct enough, consider focused China funds like the iShares China Large-Cap ETF (FXI). This ETF has top holdings headquartered directly in China, including Chinese oil majors like PetroChina (PTR), Internet giant Tencent Holdings (TCEHY) and the massive Agricultural Bank of China (ACGBY) to name a few.
And, of course, you could buy any of those individual China stocks, presuming you are comfortable doing your own research on a company that’s halfway around the world, and presuming you understand the risk of investing in a state-run enterprise like PetroChina that has the blessing of Beijing and a much higher likelihood of corruption, waste or murky reporting practices.
It’s also worth noting that Beijing just approved the first ETFs to track mainland China stocks -- not ADRs or Hong Kong-listed issues like the companies that make up the FXI. Though the distinction seems academic, the advantage for investors is exposure to players that do not list abroad as well as the ability to trade equities that move during China market hours during the Chinese news cycle instead of on New York time halfway around the world.
These funds aren’t on the market yet, however, so for the time being I would recommend sticking with multinationals or dedicated China funds if you like this investment strategy.
There’s obviously risk in China, and the hopes of recovery right now could be just another head fake.
But there are risks in U.S. equity right now, too.
If you’re rebalancing at the end of the year or taking money off the table in cooling tech stocks, it may be worth looking into Chinese stocks instead of some of the frothy picks on U.S. markets right now.
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