China—Sacrificing Short-term Volatility
for Long-term Gains

China was the party capital of investment growth in 2009; but in 2010 and so far in 2011, it’s turning out to be quite the opposite as far as performance goes. However, in the long term, China still thinks it's a potentially very rewarding bet.China was the party capital of investment growth in 2009; but in 2010 and so far in 2011, it’s turning out to be quite the opposite as far as performance goes. In 2010, the Shanghai Composite Index (SCI) fell 14.31%. In 2011, the SCI had been up over nine percent following the Chinese New Year in February, but it has been a rocky road since. The index has fallen 2.21% this year, is down 13.81% from its 52-week high, and is vastly underperforming the U.S. markets.

My investment advice is to ignore the short-term volatility and look to the longer-term for price appreciation.

It continues to be an extremely rough ride for small Chinese stocks, specifically those formed via reverse mergers; yet, much of the selling may be overdone.

China’s economic growth continues to be stellar, but inflation is an issue. Inflation in China surged to 5.5% in May, the highest level in about three years. The country’s consumer price index (CPI) could hit a staggering six percent in June, according to the National Development and Reform Commission (NDRC) in China.

In response, the Chinese central bank has increased the bank reserve ratios in an effort to stall lending. I also expect another interest rate increase if the situation does not improve.

Factory orders are slowing. This is more confirmation of some stalling in China’s economic engine, which will have an impact on economic growth and other global economies that deal with China, including Europe, India, and the U.S.

The country’s GDP is slowing. For 2011, GDP is estimated to grow by 8.7%, according to the World Bank. The growth is well down from the double-digit growth in 2010. Again, despite the stalling, the growth is well ahead of the U.S. and Europe.

In fact, economic growth in the Asia -Pacific region is promising, such as seven percent growth in the developing Asian economies and a stellar 8.3% for China’s neighbor, India. You continue to have all of the ingredients in the Asia-Pacific region for above-average long-term price appreciation and I recommend putting some capital there.

Companies continue to invest heavily in China. Just take a look at the foreign automakers and the billions they are investing in China. We are seeing more technology companies moving key research to China. The fact is that China will continue to offer companies growth opportunities outside of its respective domestic borders, whether in the U.S., Europe, or Japan. Foreign direct investment continues to be strong. What is impressive is that companies with foreign investment employed about 45 million people in China.

The concern that I have has more to do with the short term. The fear is obviously the high inflation that needs to be controlled. The country is working hard to rein in loans and easy money and is establishing tight restrictions on property speculation. The rise in the value of property has been staggering, but is showing some slowing in recent months.

In addition, the slide in the Euro along with the economic growth issues in many regions of the Eurozone could drive down the demand for Chinese goods if a double-dip recession materializes. China has been buying up European debt, which will give the country more influence.

In the short term, there are major risk factors hindering the economy and stocks. In my view, the risk is much higher now, especially in the small-cap Chinese area. Avoid any reverse-merger Chinese stocks for now due to the high downside risk.

The key is patience to withstand the market jolts and believing in the long-term prospects of China. Buying on market dips make sense.

The near term poses plenty of risk, but, longer-term, I continue to favor China as a growth area for trading opportunities. Just be very careful.