The World's Next Big Stock Rally

Place your bets now that China will push for a rally as a huge political shift takes place November 8. Whether it can fix a struggling economy is another question, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

Maybe Spain will formally request a bond-buying program from the European Central Bank in the next few days, setting off a global stock market rally. But my bet on a macro trend to drive global stock prices over the next four to six weeks would be on China.

The Communist Party finally announced a date—November 8—for the 18th party congress that will formally transfer power to Xi Jinping and a new (or "newish" anyway) group of leaders for the next ten years.

Investors have been waiting, increasingly tensely, for the party meeting date. Each day that passed without an announcement raised fears that the transition would be tumultuous. So there was a small but still audible sigh of relief on Friday, when the schedule was finally set.               

The odds are good that investors will drive the prices of Chinese stocks higher as soon as the National Day Golden Week holiday, which began Monday (with an estimated 85 million Chinese hitting the road), ends.

Last week, stocks in Shanghai started to rally on speculation that the government would use the holiday period (when the stock market is closed) to announce new stimulus measures and new rules to encourage stock buying. Let's handicap the odds that Chinese markets will see that rally continue after the holiday.

2 Reasons for a Rally
First, valuations on the Shanghai market are extremely low. The Shanghai Composite Index is valued at 10.3 times estimated earnings. That compares with the S&P 500, which trades at 14.19 times projected earnings, 12.6 times projected earnings for the London FTSE-100 and 35.68 times projected earnings for Tokyo's Nikkei-225.

Now, there's absolutely no reason a cheap market can't get cheaper, but the Chinese media have been full of statements like this lately: "History shows that a low market valuation tends to be followed by a considerable rebound," Liu Ti, the director of the Financial Innovation Laboratory at the Shanghai Stock Exchange, said last week. The laboratory also reported that blue chips (however defined) in Shanghai are trading at the lowest level in history.

Second, continued bad economic news has heightened speculation that the government and the People's Bank will move more forcefully—sooner rather than later—so that the new leadership team will take over an economy that is showing accelerating growth.

From this perspective, the just-released report that the manufacturing sector contracted in September—for a second straight month—is actually good.

The Purchasing Managers' Index was below 50, indicating a contraction, marking the first two-month decline since 2009, a survey for the National Bureau of Statistics and the China Federation of Logistics and Purchasing indicated. This increases pressure for government measures to reverse a stubborn economic slowdown.

The index came in at 49.8 in September. That was better than the 49.2 reading in August, but it still indicated the economy was contracting. And it was below the 50.1 median forecast from economists surveyed by Bloomberg.

From this point of view, even bad economic and financial news from Europe (unless it turns deeply scary) can be seen as a plus, since slower growth in China's biggest export market will goad Chinese officials and regulators into earlier action.

On this kind of thinking, Shanghai stocks rose 1.45% on Friday and gained 2.96% for the week. That gave the index a 1.91% gain for the month to snap a retreat of four consecutive months.

Betting on the Government
You'll notice that all this is about sentiment, and attempts to read the tea leaves to predict what twists and turns that sentiment is apt to take. Certainly, investors can't yet see any fundamental improvement in the Chinese economy that would lead to higher earnings, supporting Shanghai stocks at higher prices.

In fact, what we can tell of upcoming third-quarter earnings argues that large swaths of the Chinese economy will report falling profits, if not outright losses. Already, leading Chinese companies such as Baidu (BIDU) and critical Chinese sectors such as the steel industry have guided stock analysts to expect hard times.

But stock markets look ahead, so it wouldn't be unusual if the Shanghai market were looking past a rocky third quarter and anticipating a better fourth quarter.

In addition, the Shanghai market also normally moves on attempts to predict changes in government policy. Traders in that market frequently buy and sell in an effort to profit from shifts in government policy and the timing of those shifts. In that context, a rally here wouldn't be unusual.

Do you want to put some money into a potential rally built on speculation about sentiment, built on the crowd's anticipation of a change in government policy? If I put it that way, your answer is almost certainly no.

But how about if I argue this way: The Shanghai Composite Index is down 70% from its all-time high in October 2007, and down more than 40% from its post-financial crisis high in August 2009. The index is trading at the same level as in mid-2001. The stock market of one of the world's fastest-growing economies has gone nowhere in a decade. Isn't it ready for a period of outperformance?

Especially if China and other emerging stock markets reestablish the kind of anti-correlation to developed markets that they've shown for a good part of recent history—until the European debt crisis, in fact. From a long-term point of view, the recent period where Chinese stocks tanked when European stocks stumbled has been the exception and not the rule.

If China can reaccelerate its rate of economic growth, aren't investors looking at a return to a period of anti-correlation, when problems in developed stock markets are met with a period of outperformance for Chinese stocks?

You might recognize this as just another version of the Shanghai-market-has-to-go-up-because it's-so-cheap story above, but with a different, more global set of statistics.

Like the more purely Chinese version of the story, it is based on a belief that an acceleration in growth—not visible now—is around the corner. We can't yet see signs that the current stimulus has had any effect on growth, but we're convinced, this view goes, that the government is about to increase the speed and volume of its stimulus measures, and that those new measures will work.

Frankly, I think I'd put more faith in the theory that Chinese stocks will rally on speculation that the government will move than I would in the theory that stimulus will actually work this time.

I'm just about positive that the government will announce new stimulus measures in the weeks leading up to the party congress, then pile on even more after the congress in order to show the vigor and control of the new leadership after what many Chinese analysts are now calling a period of drift. Those announcements in and of themselves will likely be enough to fuel a rally.

But Is it Real Growth?
I'm much less positive that those stimulus measures can accelerate growth.

In the last couple of months, I've given you a laundry list of drags on the Chinese economy that have rendered investment-focused stimulus measures much less effective now than in 2008 and 2009:

• Local governments have announced huge programs of new investment of the sort that jump-started the economy after the Lehman bankruptcy, but this time local governments are so strapped that actual spending may fall further below announced totals than usual.
• Banks are sitting on huge portfolios of—unreported—bad loans that inhibit their willingness to lend, especially since so many of the state-owned companies in China's export sector are showing falling sales and profits—or would be if the government at all levels wasn't propping up sales. (For example, local governments have been subsidizing local steel companies, keeping blast furnaces blasting and workers working but building up large inventories of unsold steel.)
• The slowdown in Europe, China's biggest trading partner, shows no sign of reversing before late 2013 at the earliest, which makes it tough (if not impossible) for Chin to export its way to growth.

That leaves investors with some odd choices.

How to Invest in a Rally
You can, of course, sit out any possibility of a speculative rally. Though such a rally would be quite explosive if it did occur, that doesn't mean you have to chase it. The downside risk probably isn't huge with the Shanghai Composite near 2,000, but that doesn't mean the risk is nonexistent.

You can decide to go with the odds in favor of a relatively short-term speculative rally. The upside in the short term of the next two to three months is attractive—10% to 15% conservatively, I'd estimate.

But participating in this kind of a short-term move requires that you buy shares of exporters and industrial companies that are most likely to rally hardest, but that stand to fall hardest if the rally doesn't materialize, and that will certainly fall hard if a speculative rally doesn't turn into a real rally based on signs of accelerating growth.

Some stocks that fit this profile include China Coal Energy (CCOZY), Hong Kong Exchanges and Clearing (HKXCY), Jiangxi Copper (JIXAY), Sany Heavy Industry (SNYYF) and China Railway Group (CWYCY).

You can buy shares of these companies on the Hong Kong market as well; among those traded in New York, few have enough volume to make it easy to get out if something goes wrong.

Or you can eschew the biggest gains in any short-term rally and go for the long-term recovery in China's growth that is likely to be led by domestically oriented companies rather than exporters.

I continue to believe that the biggest stimulus measure that the government has passed recently is the promise of a 13% annual increase in the minimum wage embedded in the five-year economic plan promulgated in February.

That will mean rising incomes that will be spent on instant noodles and bottled drinks (Tingyi Holding (TCYMF) and Want Want (WWNTY) are examples), on travel (Home Inns and Hotels Management (HMIN) and China Eastern Airlines (CEA), for example), Internet services and shopping like Tencent Holdings (TCEHY) and financial services such as insurance companies Ping An Insurance Group (PNGAY) and China Life (LFC).

These stocks won't fall quite as hard as their export-dependent counterparts if China's growth rate disappoints, but they will decline. I'd recommend buying them with a strategy in place for an exit if the economic fundamentals don't live up to speculative anticipation.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Home Inns and Hotels Management, Hong Kong Exchanges and Clearing, Jiangxi Copper, Ping An Insurance Group, Tencent Holdings and Tingyi Holding as of the end of June. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.