Is It Time To Give Chinese Stocks The Green Light?

Chinese stocks opened notably higher to kick off the week and have rallied sharply off the March lows. Many investors have allocations in their portfolios to emerging markets which normally include exposure to China. After a long and gut-wrenching decline spanning over a year that has tested even the most patient of investors, the question now is – are Chinese stocks ripe for a turnaround?

China is the world’s most populous nation. It boasts the second-largest economy and a flourishing, expansive middle class. The rise of the middle class is likely to lead to higher consumer spending over time, and companies should naturally benefit from the increased economic growth.

In the past, China has refused to allow U.S. auditors to review the books of Chinese companies. As a result, the U.S. has threatened to delist these companies from domestic exchanges. But in recent weeks, notions of a possible compromise have come to light. According to Bloomberg, Beijing has signaled support for Chinese companies listed in the U.S. and may be willing to give auditors full access to more than 200 Chinese companies. The hints of optimism have contributed to the strong Chinese equity rally.

Yet numerous risks still remain. Due to a recent surge in COVID-19 cases, China has reinstated restrictions as it faces the biggest outbreak since early 2020. Increasing lockdowns will likely translate to a downward shift in production and demand. The Chinese government has a history of focusing on anti-competitive behavior which has hurt Chinese stocks in recent times.

Over the past year, Chinese tech stocks have rattled global markets as they experienced severe drawdowns. The KraneShares CSI China Internet ETF (KWEB - Free Report) was down about -80% from the highs hit last year. KWEB has now surged over 50% off the lows in March and investors are wondering if there is a lot more upside for this move.

On a relative basis, the KraneShares CSI China Internet ETF has been steadily underperforming the Nasdaq over the past year. We can see the ratio between KWEB and the Nasdaq in the chart below. Notice the steady descent and the pattern of lower highs and lower lows.


Image Source: StockCharts

One of the top KWEB holdings at 7.4%, (JD - Free Report) is a stock that exemplifies the volatile movements. The stock dropped about 60% from the highs last year but has now rallied more than 50% off the March lows. Despite the recent movements, JD is overvalued with a 30.62 forward P/E compared to its industry group (25.48).

A Zacks Rank #5 (Strong Sell) stock, JD is part of the Zacks Internet – Commerce industry, which ranks in the bottom 10% out of approximately 250 industry groups. JD has been witnessing a steady batch of negative earnings estimate revisions and is slated to report Q1 earnings on May 18th.

The issues in China translate to problems for investors in diversified emerging market equities. In recent years, China has become much larger in terms of weight in several widely-used emerging market funds. Index providers have steadily increased their exposure to Chinese equities, an ostensibly active decision that may be a shock to passive investors.

The notion of China weighing down emerging markets is far from a new reality. While certain emerging markets may represent attractive valuations for the value-focused investor, notice how emerging markets have fared much better when we strip out China:


Image Source: StockCharts

While investing in some of the beaten-down Chinese names may be tempting, ideally we’d like to see this ratio turn the corner and show some signs of improvement before increasing exposure. Risks are still high for Chinese equities and better opportunities exist in the current investment landscape. Rather than attempt to catch a falling knife, it’s likely a better idea to wait for more signs of a turnaround.

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