Playing a Potential Drop in Chinese Stocks

A way to take advantage of current pessimism

For investors who are increasingly bearish on the prospects for the Chinese stock market, there is a way to take advantage of that pessimism.

The UltraShort FTSE/Xinhua China 25 ProShares (FXP 85) is an exchange-traded fund (ETF) built to take advantage of declines in the Chinese equity market, specifically the FTSE/Xinhua China 25 index.

China has been one of the best performing equity markets over the past year. The Shanghai Composite is up more than 100% since the beginning of 2007, compared with a much more modest gain of 39% for the broader MSCI Emerging Markets index. However, the Chinese market has fallen about 12% since its peak on October 16, as investors have become concerned about the lofty valuations of the domestic market.

The rapid appreciation in Chinese companies' shares on the mainland has outstripped the performance of their shares listed in Hong Kong. One example of this was the November initial public offering (IPO) of PetroChina (PTR 184) in Shanghai. After the listing, the shares surged 163%, giving the company a $1 trillion market capitalization (double that of ExxonMobil) and making it the world's largest publicly traded company. This enormous appreciation also highlights the disparity in valuation between the mainland shares and those trading in Hong Kong. PetroChina's Shanghai-listed shares are trading at about 50 times earnings, compared with its Hong Kong and New York shares, which trade at about 20 times earnings.

In addition to these rich valuations, China has taken steps to rein in the economy, which may further dampen local investor sentiment. The China Banking Regulatory Commission (CBRC) has reportedly clamped down on bank lending, which has fueled the country's economic boom. The CBRC has asked local banks and Chinese subsidiaries of foreign banks to ensure that loans outstanding at the end of the year do not exceed the total outstanding at the end of October. In addition, China's commerce ministry warned that any significant slowdown in the U.S. economy could crimp China's export growth.

The potential for slower economic growth and the concerns about valuations suggest to us that the local Chinese market may be set for a pullback. If so, investors may be able to profit from purchasing the UltraShort FTSE Xinhua China 25 ProShares. Gains in this ETF correspond to twice the inverse of the daily performance of the underlying FTSE/Xinhua China 25 Index. That means that investors should gain twice as much as any decrease in the index. Conversely, if the FTSE/Xinhua China 25 rises, investors in the UltraShort ETF would lose twice as much as any rise.

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