This Chinese Stock Indicator Is Flashing Green, And It’s Never Been Wrong

This Chinese Stock Indicator Is Flashing Green, And It’s Never Been Wrong
Reda Farran, CFA

about 1 month ago2 mins

Chinese stocks just can’t seem to make friends these days. With a housing market slump, rising geopolitical tensions, subdued consumer confidence, and not a lot of stimulus measures from the government, the country’s shares have fallen sharply out of favor. And that’s got to make you think: with pessimism about the country’s prospects so high right now, perhaps it would pay to be a contrarian. And at least one indicator suggests it would: the “risk premium” of Chinese stocks has reached a level that has historically been associated with fantastic returns over the next 12 months.

This risk premium measure, sometimes referred to as the “Fed model”, compares the stock market’s earnings yield to the yield on long-term government bonds. When stock valuations fall, their earnings yield – the inverse of their price-to-earnings (P/E) ratio – rises. Put differently, a high earnings yield means that the P/E is low and stock prices are cheap, compared to earnings. Similarly, the higher the yield on bonds, the cheaper they are. So if you look at the difference between the earnings yield and long-term government bond yields, you've got a handy – though rough – guide for the relative appeal of stocks versus bonds.

Today, at around 8%, the earnings yield of the CSI 300 Index of Chinese stocks stands 5.7 percentage points higher than the yield on 10-year Chinese government bonds. That gap has rarely been this wide in the past two decades. And, for the first time since at least 2005, the CSI 300’s dividend yield has surpassed the yield of long-term bonds. In essence, this all indicates that Chinese stocks are dirt cheap. Or, if you prefer a more traditional yardstick, you could look at the P/E ratio, based on expected profits for Chinese companies: it’s sitting below 10x – roughly half the global average.

Now, what's notable about the Chinese version of the Fed model is its historical reliability in forecasting future stock returns. Over the past two decades, there have been five instances when the stock-bond yield gap has exceeded 5.5 percentage points, including during the 2008 financial crisis and the 2020 pandemic. Following each of the five periods, stocks rose over the next 12 months, yielding an impressive average return of 57%. That said, Chinese stocks’ cheap valuations haven’t proved to be enough of a draw for investors lately. But for those brave enough to take a contrarian view, it may at least be reassuring that history’s on their side.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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