Don’t chase China’s FOMO rally

Now that China has suddenly become the best-performing market in the world, investors need to recognize how much the gains are being driven by Beijing’s bolder steps to revive the nation’s sluggish economy and how much is just fear of missing out. They should proceed with caution.

Despite a nearly 10% pullback in the past week or so, the MSCI China index has still gained around 20% in the past three weeks since Beijing signaled that it will roll out a slate of stimulus measures. That caught many investors by surprise after they had trimmed their positions in Chinese stocks in the past few years. The Chinese market has been beset by an implosion of the housing market and a regulatory crackdown on its leading technology companies.

Global mutual funds were underweight China by around 3.1 percentage points at the end of August, according to Goldman Sachs. They have had to rapidly add to their positions to avoid underperforming the benchmark, fueling recent gains. Turnover hit record highs in both Hong Kong and mainland China’s stock markets. Even after the recent rally, MSCI China is still at around half of its 2021 peak.

China is such a hot theme that U.S. individual investors paid more attention to it than a U.S. market also ripping to record highs. According to ETF.com, four of the 10 exchange-traded funds with the largest inflows last week were China funds, creating a rare period when foreign stock ETFs handily topped inflows into domestic stock ETFs. Domestic individual investors have hopped on board, too, with Chinese state television reporting that there was a record number of brokerage accounts opened during the recent seven-day national holiday.

The price certainly seemed compelling: The Hang Seng China Enterprises index, a gauge of Chinese stocks listed in Hong Kong, was trading at just eight times forward earnings in early September. The ratio now stands at 9.7 times, still below the 10-year average of 11.3 times. By comparison, the U.S. benchmark S&P 500, which just touched a fresh record high, fetches nearly 24 times forward earnings.

Beijing is addressing some of the key issues that plague China’s economy. The government said it has ample room to expand its fiscal deficit and plans to take the “boldest measure" to solve the debt issues at local governments. Those governments are starved of revenue from land sales because of the slumping housing market, which in turn has limited their ability to provide a boost to the economy. The central government will likely need to share some of the debt burden.

If the fiscal stress at the local government level can be alleviated, they will have more room to tackle the problems of millions of unsold apartments. Beijing said in May that it would let local governments buy these homes to use as affordable housing, but that hasn’t happened on a large scale so far because of their own dire financial situation.

The exact size of the stimulus remains hard for investors to pin down, though, which is why markets have fallen back lately. Investors might indeed be getting ahead of themselves. Such big changes to the budget will need the approval of the National People’s Congress, China’s legislature. Its standing committee will only meet later this month, which is when specific numbers will be announced.

Even then, the package might still underwhelm investors. The process of easing the fiscal burden of local governments to stimulate demand could take a long time to work out. Meanwhile, providing big, direct stimulus to boost consumption seems unlikely as Beijing has long preferred supply-side measures. And housing inventories might take years to digest, even if the plan for local governments to buy some of those unsold apartments works out. And there is also the not-insignificant question of what can replace the housing market as the growth engine of the economy.

There are indeed reasons to be more hopeful this time than the false dawns for Chinese stocks in the past few years, but the road to recovery will likely be gradual.

Write to Jacky Wong at jacky.wong@wsj.com