Chinese stocks are one of my favorite value plays for 2015. Just don’t fall in love with them. The mantra of the permabull is to buy and hold stocks for the long run. That sounds good, and history has generally been on the side of the optimists. But buying and holding can also be a horrendously bad idea.
Consider the case of Japan. High starting valuations, chronic deflation and lousy demographics have caused Japanese stocks to slump into a multi-decade bear market. Had you bought the Nikkei 225 in 1989, your portfolio would be worth less than half your starting value today.
Let’s jump back into Chinese stocks and why I consider them to be a fantastic buy at current prices. I’ll start with one of my favorite valuation metrics, the cyclically-adjusted price earnings ratio (“CAPE”). The CAPE smooths out the volatile ups and downs of the business cycle by taking an average of the past 10 years’ worth of earnings.
Don’t worry, you don’t have to do the math. Research Affiliates, the research firm led by “smart beta” pioneer Rob Arnott, recently created a great research tool that enables you to choose any eight world markets and compare their valuations. Research Affiliates then takes it a step further by forecasting the expected return over the next 10 years based on those valuations. For those who like to delve into the nitty-gritty details, the forecasting methodology is explained here.
Chinese stocks currently trade at a CAPE of 14.6. That may not sound exceptionally cheap until you see that their median CAPE over time is 18.5 and their pre-crisis high CAPE was nearly 50. Arnott and company estimate that Chinese stocks are priced to deliver inflation adjusted returns of about 7% per year over the next 10 years.
Rival estimates by Wellershoff & Partners put the estimate at nearly double Arnott’s. But however you slice it, Chinese stocks are cheap.
There is one other major reason to expect Chinese stocks to perform well. China’s central bank is expected to step up its stimulus plan following a string of disappointing data. The People’s Bank of China lowered its benchmark rate last month, and China watchers expect a cut to bank reserve requirements.
These expectations are already showing up in Chinese stock prices. TheiShares China Large Cap ETF (NYSEARCA:FXI) has quietly been rallying since October and is within striking distance of a new 52-week high.
Chinese Stocks: Long-Term Sell
Now for the bad news. Looking longer term, China has a bleak future. In fact, I would go so far as to say China has no future.
China has had a major birth dearth over the past 30 years due to the One Child Policy. That actually gave China something of a demographic dividend, as man hours that would normally have been spent raising babies were instead diverted to industrial development. But in the process, China sacrificed its future.
Children are the future. You need them to pay the taxes and man the factories of tomorrow. More critically, in the age of modern consumer capitalism, you need them swiping the credit cards and buying the homes of tomorrow. This is particularly relevant for China given its government’s stated goal of reorienting its economy away from exports and towards domestic consumption.
Of course, children require mothers to bring them into the world. And they are about to be in short supply.
China’s population of women of prime childbearing age (25-29) goes into steep decline starting next year. Average age of marriage and first childbirth are rising worldwide, and as a general rule the more developed a country becomes (and the more educated its women become) the higher the age of marriage and motherhood.
So, let’s assume that China’s women are postponing motherhood under their early 30s. Even then, China has a major problem. Its population of women aged 30-34 goes into steep decline starting in 2020.
Conception is still possible into the late 30s and 40s, of course. But it gets more difficult and, realistically, it limits family size.
What does all of this mean?
Chinese stocks are cheap today and generally hated and underowned by investors. In a world in which American stocks trade at nosebleed valuations, Chinese stocks are a bargain.
Just don’t fall in love with them. Given the deflationary demographic abyss China faces, Chinese stocks are a long-term sell.
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