Everybody loves a comeback story. And China’s stock market has been the biggest comeback story of 2019.
The worst-performing stock market last year, China is already up 30 percent this year. By comparison, the S&P 500 is up 16 percent.
That makes China the world’s best-performing stock market year-to-date.
And Chinese stocks have plenty of reasons to keep going higher…
For starters, MSCI is quadrupling its weighting of Chinese stocks.
MSCI is one of the top providers of indices, which are tracked by an estimated US$14.8 trillion worth of managed funds.
The increase in weighting will happen gradually in three stages (May, August and November of this year). And it will result in as much as US$125 billion of funds flowing into Chinese stocks included in the MSCI indices.
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Optimism about a potential trade war deal between the U.S. and China is also pushing up Chinese stocks.
U.S. President Donald Trump’s temporary truce with China in December has already led to the postponement of new tariffs on Chinese exports.
Chinese Vice Premier (the equivalent of a cabinet member in the U.S.) Liu He met with President Trump last week, and agreed to continue negotiations for another four weeks. If a deal is reached that includes lifting the existing tariffs, China’s stock markets could soar higher.
Manufacturing in China is also showing signs of recovery after three consecutive months of contraction.
In March, the Caixin China General Manufacturing Purchasing Managers’ Index (PMI) hit 50.8. (A figure above 50 is considered expansion, while a figure below 50 is a contraction of activity.)
With trade war tariffs still in place, growth in China’s manufacturing sector indicates that domestic demand remains strong.
February is also traditionally the slowest month for U.S.-China trade, which means – tariffs or no tariffs – trade will pick up beginning in March.
Lastly, China is one of the cheaper markets in the world based on its cyclically-adjusted price-to-earnings (CAPE) ratio of 15.9 times.
(The CAPE ratio considers earnings over a 10-year period to smooth out fluctuations in earnings and adjusts for inflation.)
That compares with a CAPE ratio of 23.9 times for Japan, 29.8 times for the U.S. and 23.3 times for the global average.
So Chinese stocks have more room to run. But that doesn’t mean the ride won’t be volatile…
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Retail investors drive China’s stock market
China’s stock market is dominated by retail investors, who are estimated to hold 75 percent of the free-float (shares held by investors other than insiders).
That compares with the U.S., where households – through their personal accounts or retirement savings accounts – own about one-third of available free-float.
Retail investors are often driven by emotion and more likely to make irrational investment decisions. That makes China’s market particularly vulnerable to volatility.
For example, since 2001, China has experienced six years of annual stock market moves of 25 percent or more, compared with just four times for the S&P 500 Index.
Chinese stocks have seen moves of 50 percent or more in five of those six years that the market went up at least 25 percent. The S&P 500’s biggest move was a 38.5 percent decline in 2008.
To lessen the volatility in its stock market, the Chinese government allowed its US$600 billion pension fund to invest in the stock market in 2016. It also allows foreign investors to trade as much as US$8.3 billion worth of China-listed stocks a day through Hong Kong.
But as long as retail investors account for the majority of stock market ownership, Chinese investors will see more volatility driven by changing sentiment.
Two things that could change sentiment for the worse
One of the biggest risks to China’s stock market rally is, ironically, one of the reasons why it’s been doing so well – expectations of a trade war deal.
If the U.S. and China fail to come to an agreement soon, or if President Trump walks away – just as he did during nuclear discussions with Kim Jong-un in Vietnam – China’s markets could fall.
Even if a trade deal is reached and the market believes China is giving up too much, Chinese retail investor sentiment could sour.
A second risk is that President Trump starts another trade war with a different country. We’ve already written about the possibility that Japan could be the next casualty because of its enormous trade surplus with the U.S.
Trump could also set his sights on Vietnam, where China has shifted a lot of its low-cost manufacturing over the years. U.S. tariffs on Vietnamese exports – mostly from Chinese-owned companies – could be another blow to investor sentiment in China.
How to prepare for volatility
China could very well continue to rise 50 percent or more, so Chinese investors shouldn’t sell their stocks.
But it’s important to protect your assets from volatility.
Also, make sure to use stop losses on your investments. They help protect your gains during steep market drops, and they limit your losses to preserve your capital for future reinvestment.
Finally, make sure you keep some cash on hand to jump on opportunities that open up during volatile periods.
Editor, Stansberry Pacific Research