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This is a follow-on to an earlier article titled Investment Strategy for Volatile Markets – Embrace Volatility.

The DJIA closed out May at 10,137 - down 1,171 points or 10.3% from the April intra-day high of 11,308. It has been widely reported that May 2010 was the worst May for the index since 1940. What was not reported was that May 1940 was followed by five consecutive up months. On this occasion I strongly suspect we will not enjoy a similarly long surge - beware of Greeks bearing further gifts later this summer. However, a growing number of respected commentators and chartists seem to agree that we have put in a recent low, that markets are set to advance during the next few weeks and that the VIX will drop from the current 30 mark towards or under the 20 level.

From a fundamental viewpoint, nearly all the main economic indicators have been pointing north recently and we face the prospects of a strong Q2 2010 earnings season commencing in July. Against this positive backdrop stocks will likely advance ahead of Q2 earnings release. With overall market averages moving up, this will enable high beta stocks, which have been beaten down the most, to stage a profitable rally.

Some of the most severely beaten-down stocks in the recent slump are Chinese. At first look this is not surprising given the volume of the related negative newsflow. In particular, there has been lots of market place commentary about tighter lending practices in China aimed at quelling the booming residential property market. One such well know pundit, Jim Chanos, has made high profile appearances on CNBC and Bloomberg TV to spread his belief that ‘China is on a treadmill to hell’. And whilst Chanos is of course talking his own short book, he is not alone in predicting a slowdown. In fact the broad consensus view is that China’s economic growth will slow, and that property prices will soften for some period, particularly in eastern coast cities. Even the oft-maligned OECD is predicting reduced growth for China.

In essence during the past five weeks Chinese stocks have been hit from several sides:

  • Greek and other European sovereign debt problems has caused fear levels to sky-rocket for US investors and they are avoiding virtually all non-USA stocks.
  • In a declining US market small, high beta stocks naturally drop more than large mega-caps.
  • Tighter lending practices aimed at quelling residential property speculation in China.
  • Talk of knock-on reduced economic growth from the property slowdown in China – which will happen to some degree - and the European debt issues has added fuel to an already raging fire.

The reality, as is often the case in a world skewed by the excesses of wall to wall business TV reporting, is immeasurably better than the perception. In fact the latest OECD forecast shows a decrease in Chinese growth from 11.1% in 2010 to 9.7% in 2011. Not bad for a country that has the added security of enormous reserves - $2.447 trillion at March 31, 2010, up $174 billion in the past six months. These reserves plus the country’s ultra-competitive labor force, will assuredly keep the juggernaut chugging along at a lively clip for many years. Even factoring in a perfectly reasonable slowdown, let’s say for the sake of conservatism that growth will be 7-8%, China will still have long term growth prospects that can only be envied by many nations of the world.

Valuations for Chinese stocks have fallen to unusually attractive levels over recent months. The Shanghai Composite Index, invariably seen as being perennially overpriced, now stands at 2,568, equating to a p/e of 15.0 for 2010 and 12.5 for 2011. Given the lively growth prospects in China versus those of the USA (long-term sub 3% growth in Pimco’s ‘new normal’), the Shanghai Composite represents better value than the US main indices. For example, the S&P 500 index which closed Friday May 28 at 1,089, represents a 2010 p/e of 13.5 and a 2011 p/e of 11.5.

US investors, who wish to Embrace Volatility, and participate in the short-term trade available during the next few weeks as global markets advance, may do so via Chinese companies quoted in the USA. In all, there are over 200 Chinese stocks listed on US markets. By eliminating all pink-sheet stocks, all OTC market stocks, and all main market stocks that are simply too small or have inadequate analysts coverage, there remains 111 small/mid caps and 8 large caps. The full list may be reviewed here.

What is immediately clear is that many stocks on the list that are exceptionally cheap by any measure. My own preferred short-term buys are detailed in the following table. Investors will invariably wish to use their additional and company specific knowledge when identifying the stocks that should work best for their trades.

Stock Symbol

OTC:APWR

CPBY

CSR

OTC:PUDA

OTC:RINO

TSL

Share Price

$8.05

$5.30

$4.68

$9.04

$12.91

$17.50

Cash/(Debt) per Share

$4.18

$(0.21)

($0.87)

$2.14

$4.65

$(2.25)

Analyst target

$16.50

$9.67

$9.30

$18.00

$32.50

$29.33

Potential upside

105%

82%

99%

91%

152%

68%

Recent share price high

$13.73

$7.00

$8.68

$11.30

$25.65

$27.29

Premium over current SP

71%

32%

85%

25%

99%

56%

Market Cap

$279

$274

$323

$185

$369

$1,361

Daily Share Volume ‘000

1,397

1,327

1,844

494

1,044

4,350

2010 p/e

7.3

7.3

4.0

8.0

6.7

8.3

2011 p/e

5.0

6.4

3.6

4.1

5.8

8.1

Beta

3.0

2.2

2.6

2.9

3.5

3.5

Chart RSI index

41.3

44.9

38.7

49.6

38.0

38.5

Notes: All data is from Yahoo Finance. Stock prices are market close May 28, 2010. Recent share price high is from the latest 3-month period. Yahoo has not yet updated its CSR records for a just-completed 15m share offering. This will dilute CSR’s EPS by about 22% but will also strengthening its liquidity. I do not believe analyst will modify stock price targets for CSR meaningfully because of the plusses and minuses.

Investors can examine interesting chart patterns, including favorable RSI, by following this link.

The profitability of these trades will depend on the behavior of the overall market. However, across the group of stocks, a profit of 10-20% is expected and much larger profits would certainly not be a surprise in times of improving markets. This group of stocks includes an in-built safety margin in that valuations are exceedingly low, all have healthy daily share trade volumes, all companies are growing and they all have good balance sheets.

Additionally, given their combination of strong analyst ratings and high beta, the stock prices are very likely to enjoy future price spikes. Furthermore, no property related companies have been included in the list because, whilst I believe the Chinese property downturn will be shorter than many project, the sector may well be under a cloud for a couple of quarters as the country brings in more regulations to cool speculative elements.

When to buy? The up-move in markets during the next few weeks will not be straight-lined. Down days will occur and it is on such days that positions should be entered into. Best of all is likely to be early on days when futures are strongly negative at market open. As I conclude this note on the morning of June 1, futures are deeply negative on the back of four newsflow items; slower economic expansion in China, further write-offs for Euro zone banks, knock-on effect from British Petroleum taking a nasty hit on the London stock exchange, and political fall-out from the Israeli/Palestinian tragic events of May 31. None of these will have any material bearing on the strong Q2 earnings reports coming in July. Thus, today should be a good day to take positions and it is my own intention to add to those I instigated Friday May 28.

When to sell? This can be more difficult, especially as investor confidence typically rises in tandem with improving markets. It is wisest to sell early and not get caught in a confidence trap. Absent company-specific indicators, I would default to selling when/if $INDU or the specific company RSI index approaches or breaches 70 on the upside.

In the interest of full disclosure I own all the above short-term positions as part of a wider portfolio. I envision closing out all these trades before the end of the Q2 earnings season in August, or as described in the preceding paragraph.

Disclosure: Author is long all the stocks mentioned

Source: 6 Short Term Volatility Trades for Q2 2010