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'Nasty Combination' in China Could Mean 10%-20% Advance in These Funds

The Shanghai Composite staged a mini rally midweek on the heels of comments from Market Studies founder Tom DeMark that the index could rise as much as 28% by September. DeMark does have a solid track record of accurate predictions on China. In late 2012, he correctly called the rebound in China's equities.

However, while DeMark may be right about a rally by the fall, I think the more likely scenario as we enter spring will be a sell-off, and that means it's time to embrace the short side.

With all global investment eyes trained on the tiny island nation of Cyprus, it's possible you missed another piece of global news earlier in the week that, in my opinion, should have received a bit more attention.

On Monday, analysts at JPMorgan downgraded China to "underweight" in its emerging market portfolios. In his note to clients, JPMorgan analyst Adrian Mowat cited several reasons for his downgrade, writing, "The post stimulus policy environment is challenging with slowing growth and inflation fears." Perhaps most tellingly, Mowat wrote, "Growth momentum is now slowing with policy response constrained; a nasty combination."

The term "nasty combination" isn't a good one when you are talking about a country's economic climate, and its inability to correct the problem via monetary policy. So it should come as no surprise that the key exchange-traded fund (ETF) pegged to the biggest Chinese equity market index, the iShares FTSE China 25 Index Fund (FXI), took a hit on the JPMorgan downgrade.

The chart here of FXI shows the plunge that's taken place in the China fund since February, which has caused it to drop below its 50-day moving average, and almost below its 200-day moving average, all within the span of about five weeks.

FXI China Fund Chart
FXI China Fund Chart

To be certain, China's recent economic metrics have also been heading lower. So far this year, the all-important industrial output figures show the weakest start to a year since 2009. Retail sales still are growing, but at a far slower pace than in recent years.

Most troubling, however, is the news of rising home prices. The latest survey data from the People's Bank of China revealed that more than two-thirds of those surveyed (68%) said home prices are too high, and essentially unaffordable. That's the highest percentage since the final quarter of 2011. The consequence of this home price bubble is likely to be a move by policymakers to tighten liquidity and rein in credit growth. If that happens, look for Chinese equities to continue to come under pressure.

Now, in support of its call on China, JPMorgan is recommending investors use put options or short positions, particularly to hedge any exposure to Chinese financial stocks. I think this is a smart idea for traders too, but not just for financial stocks.

In fact, the short-term trend in Chinese stocks is a chance for fast-money traders to jump on the selling via a couple of ETFs designed to move opposite FXI.

ProShares Short FTSE/Xinhua China (YXI)

This ETF gives traders a way to participate in the inverse of FXI. This single-beta fund is designed to move directly opposite of FXI. For example, so far in 2013, FXI is down about 11% while YXI is up 11%. If this trend continues, we could see another 10% gain in this inverse fund.

YXI China Fund Chart
YXI China Fund Chart

Recommended Trade Setup:

-- Buy YXI at the market price
-- Set initial stop-loss at $35, approximately 8% below the current price
-- Set initial price target at $41.85 for a potential 10% gain in 2-3 months

ProShares UltraShort FTSE/Xinhua China (FXP)

This is the play for more aggressive traders, as this two-beta fund gives you twice the inverse exposure to FXI. Since the beginning of the year, FXP is up about 23%, but I don't think the gains are over yet. I suspect this fund could go up another 20% from current levels during the next few months, especially if more downbeat economic data out of China drives down the price of FXI.

FXP China Fund Chart
FXP China Fund Chart

Recommended Trade Setup:

-- Buy FXP at the market price
-- Set initial stop-loss at $18.75, approximately 8% below the current price
-- Set initial price target at $24.50 for a potential 20% gain in 2-3 months

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