Should You Invest in China or Steer Clear?

Xinhua News Agency/Getty ImagesInvestors review stock information at a trading hall in a securities firm in Shanghai, east China.
U.S. investors have enjoyed strong returns from stocks over the past six years, with stock markets recovering sharply from the 2008 recession and financial crisis that sent the Dow industrials (^DJI) to their worst level since the 1990s. Yet more recently, even as the Dow's gains have slowed, the Chinese stock market has taken off, with the Chinese equivalent of the Dow, the Shanghai composite, more than doubling in less than a year. That has a lot of investors excited about China's prospects, but some are nervous about whether the Chinese stock market has come too far too fast.

Why Is China Booming?

At first glance, the performance of China's stock market seems completely out of sync with its economic prospects. After decades of strong growth, China's economy has finally started to slow down, and while growth rates are still substantially faster than most of the rest of the world, some measures of economic activity look gloomier. For instance, profits from the industrial sector have fallen 1.3 percent so far in 2015 compared to the same period last year, as declines in prices and reduced demand for goods has offset the positive influence from reductions in interest rates.

Yet the nature of China's economic system reveals some of the reasons behind the rise. The long-term boom in China's economy has created a lot of new wealth among the population, yet there are a limited number of ways to invest within the country. Capital controls prevent most people from investing overseas, and a red-hot real-estate market has pushed prices higher and caused concerns of its own among economists seeing signs of a bubble. To stave off a housing bust of the sort the U.S. saw in the mid-2000s, central government officials started talking about the benefits of stock-market investing, and that has led to a rush of interest among Chinese investors looking to cash in on the big rise in the stock market.

In addition, international interest in Chinese stocks has helped push up demand. In the past, foreign investors haven't been able to invest directly in the Chinese stocks that trade in Shanghai and other mainland exchanges, instead having to route capital through Hong Kong. However, more recently, signs that China might open up its market to outside investment has led major international investors to look at getting into Chinese stocks. In particular, exchange-traded funds that focus on emerging-market stocks track indexes that could soon include some of these newly available Chinese stocks, and if that happens, these ETFs will essentially have to buy shares at whatever price in order to keep tracking their benchmark properly.

Why Should You Worry About China?

Those who follow the Chinese stock market have plenty of concerns about the sustainability of its recent rise. By traditional measures, valuations of Chinese stocks have soared through the roof, with some shares sporting prices that are reminiscent of the enthusiasm that U.S. investors had for Internet stocks during the late 1990s and early 2000s. If the Chinese market follows the path that U.S. stocks went down more than a decade ago, the fallout could be extremely painful.

In addition, structural deficiencies in the Chinese market could add to losses. Increasingly, investors in stocks within China have turned to margin loans, borrowing against the value of the stock they've purchased in order to buy still more shares and try to maximize their gains. When stocks go up, investing on margin leads to much higher returns. But when they fall, margin loans can wipe out entire portfolios much more quickly than simply holding an unleveraged stock portfolio, and the forced selling that can result from margin liquidation often makes stock-market declines much worse than they'd otherwise be.

Finally, the prevalence of day-traders and other unsophisticated investors within China could add to future instability. In March, 5 million new trading accounts got opened in the emerging-market nation, and many of the newest traders have limited education and experience in investing.

What to Expect

The problem in predicting the future is that even when it's clear that a stock market is in a bubble, the conditions can last far longer than you'd expect. As a result, even as an increasing number of people agree that the Chinese stock market has climbed to unsustainable levels, it could remain there for a long time or even climb higher. Eventually, though, history shows that all good things eventually come to an end, and China might soon become the latest market to find itself on the list of burst bubbles. As a result, only those who are comfortable with substantial risk and a long-term approach should consider jumping into Chinese stocks at this point.

Motley Fool contributor Dan Caplinger has indirect exposure to Chinese stocks through ETFs. You can follow him on Twitter @DanCaplinger or on Google Plus. Check out our free report on one great stock to buy for 2015 and beyond.
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