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Chinese stocks have been crushed over the past year, with its two main stock indexes down 40% and 65% – and approaching their 2008 lows. But there’s a lot of potential here too: the tunnel of tribulations and crackdowns is starting to come to an end, and its raw potential – in the tech sector, in renewable energy, and more – is the light glimmering at the end. So is it time to buy the dip?

Why have China’s stocks fallen so far?

Cracks started to appear in the Chinese stock market last year, when the government started to focus on “common prosperity” – economic equality, to you and me.

That involved cracking down on tech firms, property developers, and other major sectors, all in an effort to address the wealth gap, deflate speculative bubbles, limit financial sector risks, and reduce the power of dominant firms and entrepreneurs. Problem was, those policies probably had a stronger effect than the government intended: house prices dropped, highly leveraged property developers almost went bankrupt (remember Evergrande?), and stock prices went into freefall.

But it didn’t end there. A decade-long dispute between the US and China escalated early this year, when the US announced it would de-list Chinese companies from American exchanges unless they complied with certain requirements by 2024. With more than 200 Chinese firms listed in the US and eight of them important state-owned enterprises, the impact would be massive. That might be why the price of US-listed Chinese companies – which can be tracked under Nasdaq’s Golden Dragon China Index (ticker: PGJ) – has dropped more than 60% since the news first hit.

Adding to pressures, the Chinese government’s failure to condemn its ally Russia for its invasion in Ukraine increased fears of sanctions, in turn threatening the investability of Chinese shares. In response, the Chinese government took the unprecedented step of announcing that it would soften its stance on both the common prosperity crackdown and its dispute with the US.

Asset prices bounced higher in response, but the rally was cut short when resurgent Covid cases led the Chinese government to impose stringent lockdowns across the country in order to meet its strict “zero COVID” target. The measures hurt consumption, but also disrupted supply chains, closing factories in key hubs like Shenzhen and Shanghai and limiting the delivery of food and medicine to the population. And that brings China’s battered-and-bruised stocks to today.

Why might China’s stocks rebound?

Let’s face it, the short-term outlook looks pretty grim for China, but I’d argue that things are turning more positive under the surface. Here’s why:

Big fiscal and monetary support is on the way

Even amid a sputtering housing sector, continuing geopolitical tensions, and renewed Covid disruptions, China still announced a month ago that it was aiming to grow its economy by an ambitious 5.5% this year.

The government is heading into an “election” year, so it’s likely to do whatever it takes to avoid missing that target. That means it’ll be prepared to amp up fiscal and monetary support. In fact, the government has already announced measures to support property developers, limit financial risks, enhance credit conditions, and step up its investment – both in infrastructure and in sectors that will be key to transitioning to a more robust economic model.

And so far, the signs are encouraging: the government has issued a record number of new bonds to finance the upcoming fiscal projects, credit has recovered faster than expected, and interest rates in the country have been falling.

The government is tying up its crackdowns

The Chinese government has already softened its stance toward tech firms and property developers, and now it’s moving from the announcement phase (the big headlines) to the implementation one (the fine print). That removes a lot of the uncertainty around Chinese stocks, and may even leave room for positive surprises when it turns out that some measures aren’t workable in practice.

There are also encouraging signs that Beijing may be willing to reach an agreement with US regulators regarding disclosure requirements for its American Depositary Receipts (ADRs), which enable non-Chinese investors to buy Chinese firms listed on US exchanges. A deal is arguably likely at some point this year or next, which could act as a catalyst for an improvement in sentiment.

The government might ease its zero-Covid stance

Covid might be the biggest threat to China’s short-term outlook. But while the bear-case scenario of nationwide lockdowns would undoubtedly be a serious problem for the Chinese economy, the bull-case scenario of a gradual reopening backed by more advanced treatments would be a massive positive. And that’s looking more and more likely.

One reason for that: the government has shown some willingness to be more flexible regarding its zero-Covid stance. Given the importance of sentiment in a political year, they might be more willing to adopt an even more relaxed position in the coming months.

Another reason: the mismanagement of lockdowns in Shanghai isn’t necessarily representative of what could happen to other Chinese cities, which should be much better prepared to handle the lockdowns. By focusing on local lockdowns, the government is also buying time to acquire the vaccines and treatment drugs it needs, as well as to better organize its healthcare resources.

Chinese stock valuations are attractive

With a price-to-earnings ratio of around 10x, China’s stocks are valued at about half as much as they were a year ago, and they’ve reached levels comparable to significant previous bottoms.

What’s more, a P/E of 10x seems overly negative. Even Goldman Sachs – which has a below-consensus target for the country’s economic growth – estimates that a P/E of 12.5x is fair:

That suggests more than 15% upside on valuation alone. And if earnings improve at the same time, the upside might be well higher.

In fact, a whole variety of different factors could drive that valuation higher if they come to pass. You can see in the matrix above that if China meets its economic growth target of 5.5%, expect an extra 2.2% to its P/E ratio. A relaxation in regulation? Another 2%. But keep your eye on the horizon: higher US government bond yields or a higher oil price could have the opposite effect…

The technicals are supportive

There are a few promising signs on the charts. First, the Chinese stock market has rallied 20% since its March lows, and it’s historically never dropped below the previous low after a rally of that size. Of course, that doesn’t mean a significant fall won’t happen, but they are a lot less likely than they otherwise would’ve been.

Second, lots of speculators have left the market, while many large institutional funds are now underweight on China. That suggests there aren’t a lot of sellers around. But there could be a lot of new buyers as the environment improves, meaning they’re going to have significantly more influence over the market’s direction.

Third, the past five election years have all been strong for the Chinese market, seeing an average 35% gain in the nine months before the election, and positive returns 80% of the time. And last, Chinese firms have started to implement large share buyback programs, which has historically been more bullish for stock prices in the country than analysts have expected.

So should you buy the dip?

China’s fundamental outlook is undoubtedly challenging, and the country’s stocks are definitely a high-risk investment. But unlike US stocks, they also have a higher valuation buffer. That is to say, bad news is already largely reflected in the price, meaning the risk-reward characteristics at these levels are tempting.

If you do want to take advantage, the way you go about it depends on whether you’re an active or a passive investor.

For passive investors

There are a couple of reasons why Chinese stocks could be a good addition to your portfolio if you’re a passive investor.

First, they stand to boost your returns: they’re currently much cheaper than US stocks, and could catch up fast when the factors that are keeping them down start to ease.

And second, they may help diversify your risk. Chinese stocks are currently driven by different factors than European, Japanese, and US stocks: its business cycle is at a different stage, its central bank is easing rather than tightening, and stock prices already reflect a deteriorating environment. And that diversification could be exactly what you need right now: the biggest benefit from diversifying stock exposure came during the stagflationary period of the 1970s – an environment that doesn’t look all that different from today, given the downside pressures on growth and upside pressures on inflation.

To gain passive exposure to China, you have a few choices. First, you could buy a Chinese-focused ETF trading on a US exchange: the iShares MSCI China ETF (ticker: MCHI, expense ratio: 0.59%) ETF and the KraneShares CSI China Internet ETF (ticker: KWEB, expense ratio: 0.76% ) are your best bets. While the first is more diversified and offers a broad mix of mainland, China, and US-listed stocks, the second has a significant focus on tech and consumer discretionary stocks. That makes it a higher-risk, higher-reward option.

Given the uncertainty surrounding the immediate outlook, I suggest spreading out your investment over time with dollar-cost averaging. I also think it’s worth holding a bit of extra cash in hand, with the goal of adding to your position if prices drop another 10%-20%.

For active investors

For more active investors, I see three opportunities right now:

Idea 1: Invest in new infra

We mentioned earlier that China is focusing its policy efforts on sectors that will help drive its new economy: think green energy (renewables and grid), new infrastructure (smart roads, telecoms), and the digital economy (5G, data centers). It’s also increased its focus on sustainability and social and environmental projects.

The importance of these sectors for the Chinese government means they should continue to show strong momentum over the long term. So you might want to consider the KraneShares MSCI China Clean Technology Index ETF (ticker: KGRN, expense ratio: 0.79%), or the KraneShares CICC China 5G & Semiconductor Index ETF (ticker: KFVG, expense ratio: 0.65%) to gain exposure to these up-and-coming priorities.

If you have access to A-shares, renewable tech firm LONGi Green Energy, Internet-of-Things solution provider Hikvision, and electronics manufacturer Luxshare Precision screen attractively right now. If you have access to H-shares (those listed in Hong-Kong), you should look at consumer electronics Xiaomi, semiconductor equipment-maker Xinyi Solar, or a more traditional infra stock like China Railway.

Idea 2: Bet on mean-reversion

The further you hold a ball underwater, the higher it’ll jump when you let it go. The same could be true of the sectors hit hardest by China’s regulatory crackdowns, lockdowns, and political fears: they might’ve taken a battering, but they could ping back with renewed force once those pressures start to let up.

That’s because those sectors haven’t just been hit hard because their fundamentals have deteriorated: a U-turn in sentiment – and the subsequent exit of speculators – has exacerbated the fall. But I’d argue that while prices might deviate from their fundamentals over the short term, they always tend to go back over the long term.

The best ETFs to play this theme is the KraneShares CSI China Internet ETF (ticker: KWEB, expense ratio: 0.76%), which has a big allocation to tech and consumer cyclical stocks – sectors that were hit the most during the drawdown. Another option is the Invesco Golden Dragon China ETF (ticker: PGJ, expense ratio: 0.69%) – the one we mentioned earlier that centers on Chinese stocks listed in the US. That one could jump higher on a deal between China and the U.S. regarding ADRs.

Idea 3: Buy tech stocks

Tech stocks were hammered in the latest correction, and they’re now trading at all-time low P/E valuation of 20x their expected 2022 earnings – two standard deviations below the historical average. That’s the steepest discount versus US peers over the past decade: Chinese stocks are now trading below 1x price-earnings-growth ratio, while US ones are trading above 2x.

But despite the short-term hurdles, the long-term growth story remains largely intact. Some of the fastest-growing Chinese tech companies are now trading at attractive prices, and most of them are sitting on enough cash to buy their own stock if growth opportunities are constrained in the short term. The asymmetry looks particularly appealing for long-term investors right now, with many companies likely to resume their upward trajectory in the next few years – if not months.

To invest in tech stocks, the simplest way is to buy the Invesco China Technology ETF (ticker: CQQQ, expense ratio: 0.7%). In terms of individual Chinese tech stocks, Goldman Sachs thinks JD.com, Alibaba, Baidu and Pinduoduo look attractive, and they can all be bought in the US through their ADRs. Tencent and Meituan are also looking cheap at these levels, but they’re only available as A and H-shares. Keep in mind that these stocks also represent a big part of the Invesco China Technology ETF mentioned above.

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