Three Ways to Play a China Rebound

Submitted by Investing Daily as part of our contributors program.

Don’t look now, but China is rebounding!

After hitting a four-year low on December 3, the Shanghai Composite is now up 18.6%.

As longtime readers know, I’ve been dogging Chinese stocks for a while. (See here, here and here.)

But the key to being a successful investor rests in the ability to change your mind when conditions change. And I’m on the cusp of such a decision regarding China.

Here’s why, and – more importantly – I’ll reveal three compelling opportunities to consider…

From Boom to Bust… to Boom?

As we all know, the Great China Boom turned into the Great China Bust.

Chinese stocks vaulted almost 340% higher from January 2005 to October 2007, only to collapse roughly 60% by October 2008. But ever since then, Chinese stocks have pretty much been treading water (besides a few rallies that never lasted).

In the process, most investors all but gave up hope on any meaningful rebound in China. The preponderance of research pieces warning against Chinese stocks being a potential “value trap” epitomized the prevailing sentiment.

And lo and behold, that’s precisely when Chinese stocks appeared to put in a bottom.

Granted, all emerging markets stocks have been in rally mode since December. But the MSCI Emerging Markets Index (MXEF) is only up 7.4% since then, indicating that there’s more at play in China than simply the “rising tide lifts all boats” phenomenon.

It’s called economics…

In recent weeks, GDP growth forecasts for China jumped back above the 8% level. Additionally, other key economic metrics are rebounding, like exports, which climbed almost 15% in December.

Ultimately, all we need is for the Shanghai Composite to close above 2,351.7 to enter a bona fide bull market. That’s only about 25 points higher than current levels.

If that happens, it’ll put an end to the longest bear market in China’s history, which has lasted 756 calendar days, according to the number crunchers at Bespoke Investment Group. That’s almost a full year longer than China’s second-longest bear market on record of 461 days.

As Bespoke notes, “Should the Shanghai gain another couple percentage points, a new bull market will be at hand, and it will certainly be a welcome relief for Chinese investors.”

Indeed. Another boom in Chinese stocks is long overdue. And it appears to be materializing.

So how do we play it? It depends on our risk tolerance.

~China Rebound Option #1: LEAP Options on the iShares FTSE China 25 Index Fund (FXI)

Conservative investors should consider purchasing long-dated options on the largest Chinese stocks. The iShares FTSE China 25 Index Fund provides an easy way to do that. It invests in 25 of the largest and most liquid Chinese companies.

And the reason I recommend options, instead of an outright purchase of shares, is simple…

Options limit our capital outlay, yet they provide significant leverage to the upside. Not to mention, they offer ample time for the investment to work out.

Specifically, I’d consider the January 2014 or January 2015 $45 call options.

~China Rebound Option #2: Guggenheim China Small Cap Fund (HAO)

More aggressive investors might consider jumping into the most battered segment of Chinese stocks – small caps.

Fraudulent accounting by many Chinese small caps has spoiled investors’ appetite for all Chinese small caps. Accordingly, the Guggenheim fund sold off more than the iShares FTSE China 25 Index Fund over the last two years. But it’s in full-on rally mode now, nearly doubling the return of the iShares fund over the last three months.

Given that China is no longer the lowest-cost producer of goods, the next China boom is going to come on the backs of Chinese consumers, not exporters. That makes the Guggenheim fund particularly attractive, as it invests exclusively in small caps, which cater to China’s consumers.

If you’re not satisfied with either of the options above, the most aggressive investors might want to consider identifying individual small-cap Chinese stocks. (I shared one prospect yesterday.)

However, it’s going to require extra time to ensure that the company is, in fact, a legitimate business and not another scam. And the extra time it takes to conduct that due diligence could end up costing you profits. So just keep that in mind.

Bottom line: As John Templeton observed, the point of maximum pessimism tends to be the best time to buy. Based on the latest price action in Chinese stocks, it appears we may have reached that point. Invest accordingly.