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A man reads information on an electronic screen at a brokerage house in Shanghai (ALY SONG/ALY SONG/REUTERS)
A man reads information on an electronic screen at a brokerage house in Shanghai (ALY SONG/ALY SONG/REUTERS)

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Why China may be in a secular bear market Add to ...

China's rise over the past decade was reflected in its main stock market, the Shanghai Composite index, which is largely closed to outsiders. Shanghai soared to all-time highs near 6,000 in October 2007.

But then, it plummeted to around 1,700 -- and has just edged above 3,000, half its previous peak. It has trailed the S&P 500 index badly over the last two years, although it's slightly outperforming in 2011.

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Still, this chart shows an uncanny resemblance between Shanghai's five-year performance from the year before its peak until now and that of the Nasdaq Composite index from 1999 through 2004.

Yes, Shanghai is a momentum- and liquidity-driven market well known as a refuge for unsophisticated, short-term speculators -- a Macau for stocks.

But U.S. retail investors who chased Internet comets like Akamai Technologies and Juniper Networks weren't too sophisticated, either. That's one reason the comparison holds -- and why I think China is actually in a "secular" bear market now.

What it Means for Investors

A "secular" bear is a very long-term bear market where the major averages never quite reach their previous peaks. It can be punctuated by strong short-term rallies, even some shorter cyclical (three- or four-year) bull and bear markets.

The classic example: the 1966-1982 secular bear market in the US. Many pundits claim we're in one now as well.

During that period, the U.S. suffered high inflation, but the Federal Reserve was perpetually behind the curve, until new chairman Paul Volcker sent short-term rates soaring. That broke the back of inflation and set the stage for a new secular bull market.

The comparisons are striking. The liquidity boom that fuelled the Shanghai market's stratospheric rise stopped just before the financial crisis broke. When it resumed, speculation shifted to real estate. (Sound like the U.S. in the 2000s?) Now, inflation is outrunning expectations, while China's central bank just raised rates for the fourth time since October. In its latest five-year plan, the government has lowered its growth target, and it's likely GDP will rise only in the high-single-digit, not double-digit, percentage range.

That points to a more difficult market for Chinese stocks in coming years, although China pros are loath to use the "b" word.

"I don't think it's a secular bear market," said Henry Zhang, San Francisco-based co-manager of the Matthews China Fund. But, he added, "It may take a long time to reach the 6,000 mark again."

Indeed it may. Shanghai will re-take 6,000 when the Nasdaq scales 5,000 again -- and a choir of angels will descend from heaven singing the Hallelujah Chorus.

But if China's growth falls to "only" 7-8 per cent, that's a lot better than what we'll see here, or even in many emerging markets. And China is likely to remain a critical player in the world economy.

Plus, the government's new five-year plan puts the Chinese consumer front and center, which will mean profit opportunities for many companies in coming years, secular bear or no.

What to Avoid and What to Buy

First, I'd avoid the Shanghai market entirely and the popular exchange-traded fund iShares China 25 Index Fund , which is actually doing well this year. It's just too dominated by big state-owned oil, telecom, and banking companies.

Instead, with no more than 5 per cent of your assets, I'd pair U.S. multinationals that get a big chunk of their revenues from China and Asia with privately owned Chinese companies that focus on the emerging Chinese consumer.

The table shows the 15 members of the S&P 500 index with the highest percentage of revenues from Asia.

The overwhelming majority are technology giants like Texas Instruments , Qualcomm , and Applied Materials , whose stock performance may be more about tech than Asia.

Others include transportation and logistics company Expeditors International of Washington and tobacco company Philip Morris International .

Yum! Brands also is well known for its ubiquitous KFC and Pizza Hut outlets in China, but Carl Delfeld, managing director of the Emerging Market Trends advisory service and contributor to Oxford Club, cautions that its growth is pretty meager.

He also calls buying Asia through US multinationals "a very indirect way to do it, and diluted."

There are exceptions. Wynn Resorts gets two-thirds of its revenues from Asia, almost entirely from Macau, and it may have another Macau casino hotel in the works. Las Vegas Sands gets an astonishing 88 per cent of operating income from Asia, including two casino hotels in Macau and one in Singapore.

Both are trading well off their 2007 highs, but have rallied big time from their March 2009 lows. LVS is more diversified geographically and has outperformed by a lot in the recovery, but WYNN has been less volatile. Both, of course, would get hit by a big slowdown in China.

Where to Look in China Itself

The second part of the strategy is to find a couple of entrepreneurial, consumer-oriented Chinese companies. Delfeld likes Focus Media Holding , whose ads run on half a million flat-panel displays in public spaces throughout China.

In the most recent quarter, net income jumped 58 per cent on a 44 per cent increase in revenue. Profit margins are a sizable 36 per cent. At a recent price above $30 (near its 52-week high and up five-fold from its March 2009 low), FMCN changes hands at about 20 times this year's estimates, while earnings are growing at roughly 20 per cent annually.

Zhang of the Matthews fund likes New Oriental Education & Technology Group , a leading educational provider which he says is in the mid-cap "sweet spot" of the Chinese market.

Originally a test-preparation company, EDU now offers everything educational, from nursery school through graduate school, to 450 million Chinese consumers.

While the P/E is "quite high," he says (over 35 times fiscal 2012's estimated earnings), analysts are looking for 25 per cent annual earnings per share growth over the next five years.

Samantha Ho, manager of Invesco China Fund, favours Ctrip.com International , which books flights, hotels, and packaged tours in China.

At a recent price above $44, Ctrip changes hands at about 35 times this year's projected earnings and 28 times next year's. Ho pegs its annual earnings growth at 20 per cent, and says the company can gain share in a very fragmented market.

If you don't want to own individual stocks, I'd suggest a couple of ETFs or an actively managed regional stock fund. The Matthews and Invesco China funds have lagged recently, but rank highly for five-year performance. (Check loads and expense ratios, of course.) Delfeld says an ETF combination of iShares MSCI Hong Kong Index and iShares MSCI Singapore Index provides a "safer, softer way to tap into China's growth."

Given how treacherous that market has been and is likely to be in coming years, that sounds like a pretty good idea.

Howard R. Gold is editor at large at MoneyShow.com and a columnist at MarketWatch. You can see more of his commentary and videos at www.howardrgold.com and follow him on Twitter @howardrgold. He does not own any of the stocks, funds, or ETFs mentioned in this column.

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