Protecting Yourself From the China Bubble

by: Thomas Bustamante

We can all agree that China continues to grow at a rapid pace, but Chinese equities are also in the process of extending themselves into what many believe may be a bubble, and now may be a good time to consider providing some protection to your capital gains.

Since the subprime credit crises in mid August 2007, Chinese stocks have risen a dizzying 45%. These gains through out the sector can been seen by the percentage returns in the two main publicly traded Chinese ETF’s. Since mid August, the Halter USX China Index (AMEX:PGJ) has risen 55%, while the FTSE/Xinhua (NYSE:FXI) has risen a whopping 70%.

Small Cap Signals

One of the signs of a valuation bubble can be seen in the amazing runs on some of the small cap Chinese stocks. Usually during the height of a valuation bubble you'll begin to see speculative money flow into small cap stocks, and recent events point to a potential over speculation within the Chinese sector. Some of the recent high fliers have been China Natural Resources (NASD: CHNR), which has risen from a price of around $14 to $40 just in just the past week. Some other amazing movers this past several weeks have been China Precision Steel (NASD: CPSL), China Finance Online (NASD: JRJC) as just a few.

How to Protect Yourself

If you’re one of the many investors who has realized amazing gains in the Chinese run, you may now want to consider providing your portfolio with additional protection. Here are some tips:

1) Take some profits – if you are up big on some of these Chinese equities you may want to consider taking some cash off the table for those rainy days. Remember, cash is king.

2) Mutual Funds – you may also want to consider moving some of that cash into a mix of Chinese mutual funds. This will still give your money some percentage gains, while at the same time reducing downside risk through a diverse and managed fund. Diversify.

3) Put Options – if own some stock you just don’t wish to part with, say for tax reasons, you may want to consider using Put options to protect your holdings from any sharp market downturns. Options can be risky, and you should only use a small portion of your overall capital to provide protection. Equity insurance.

4) ETF Short Positions – another strategy may be to take short positions in some of the ETF’s as Chinese equity valuations unwind. This play would allow you to make some percentage gains on the down side, while allowing you to go long once you cover. Good tool while on the way down.

We wouldn’t recommending pulling out totally from this incredible run, as there may still be some amazing percentage gains to be had in this market. But, as Chinese equity prices continue to spike, if may be prudent to begin considering a strategy to protect ones recent gains.