A Word of Advice on Chinese Mutual Funds/ETFs: Sell Some.

I generally avoid investing advice on this blog since I get paid to worry about those kind of decisions full time and it would be a conflict of interest with my employer to discuss individual equities here. However, I am going to make some comments on China today. What appears to be going on in their local A Share market is a classic market bubble. There are many Chinese investing for the first time and they do not know the risks associated with it, hence they are bidding prices ever higher. As far as they are concerned stock prices only go up. Also, there is no short selling in the Chinese A Share market so it seems like it is easier for inefficiency to creep into the system. Sure China is one of the fastest growing economies in the world, but that doesn't mean it should carry a P/E of greater than 70 as a market.

The hard thing about bubbles is predicting their end. I don't think anyone is particularly good at doing this. However, what you can do is choose not to participate once things get too frothy. Indeed if you have some China mutual funds (US investors can't own the stocks directly) or ETFs that are hold a significant amount of A shares it might be time to cash out some of those gains. I'd recommend selling down enough so that after taxes you have recouped all of your original investment. If you want to speculate a little longer with some of your remaining gains, that's your prerogative because calling a bubble's end is hard to do and they always seem to go on a little longer than anyone expects. While things economically are looking great for China at least through the Olympics in summer 2008, how long their market can continue to sprint depends on how long people are willing to pay any price for stocks. Rest assured that at some point there will be a big pullback (we indeed may be starting to see it now) and it will spook people and remind them that risk is associated with reward and then the Chinese market will come down just like technology shares did in 2000 and more recently like home building shares have done over the last couple of years. Those that have protected their principal will be glad and those who continued to speculate (or worse, put a boatload more money in because their returns had been so good) as the bubble intensified will lose a big part of their investment.

I'm not alone in this sentiment. Even Warren Buffett said people should be cautious with China.