Generational Pair Trade

Long Dragon7, Short Magnificent7

Singapore hosted a stunning dragon-themed drone show to commemorate the Chinese New Year. This inspired me to ponder about a generational pair trade: “Long China, Short US”.

Here are some insights:

• Long China, Short US

• Long Dragon 7, Short Magnificent 7

• Trend Exhaustion

---

Long China, Short US

For the past 30 years, the S&P500 Index/Hang Seng Index (SPX/HSI) has always traded closely due to the intertwined relationships between the US and Chinese economies. The 30-year mean is around 0.0947.

Historically, the spread between the two indices has never traded higher than 0.3. Now, it is trading at 0.319, at an all-time high.

Moreover, there exists a stark contrast in valuation. The S&P500 Index trades at a hefty 22.6x P/E ratio with a projected 9% next-year EPS growth, whereas the Hang Seng Index trades at a modest 8.1x P/E ratio with an anticipated 7% next-year EPS growth.

This difference in valuation presents a once-in-a-generation “Long China, Short US” pair trade opportunity for investors.

Long Dragon7, Short Magnificent 7

The best way to play the “Long China, Short US” trade could be the leading China and US tech stocks:

• Dragon 7: Alibaba, Baidu, PDD, JD, Netease, Tencent, and Meituan)

• Magnificent 7: Apple, Microsoft, Amazon, Alphabet, Nvidia, Meta, and Tesla)

Currently, the spread between the Magnificent 7 and Dragon 7 stocks is trading near multi-year highs of 2.89. This presents a compelling risk-reward opportunity for investors to participate in this trade.

This year, the Dragon 7 stocks have experienced an average decline of 7.3%, a correction divorced from the intrinsic merits of these enterprises. Rather, external forces from overleveraged sectors such as real estate, have weighed heavily on their share prices.

This disconnect is stark when considering the robust fundamentals underpinning the Dragon 7 stocks that are fortified by net-cash balance sheets and steady EPS growth.

Moreover, the Dragon 7 stocks are trading at a bargain valuation of 14.3x P/E, with an EPS growth of 13% next year. The highest EPS growth of 30% and 36% comes from PDD and Meituan respectively.

Therefore, the best proxy for the "Long China" trade is the Dragon 7 stocks, serving as a beacon of resilience in the China market. This could potentially be the best trade for this Dragon Year.

On the other hand, the rally of the Magnificent 7 stocks appeared to be overextended with an average 11.5% increase this year.

This represents a staggering $12.5 trillion rise in market cap. To put this in context, this rise is above the combined GDP of New York, Tokyo, LA, London, Paris, Seoul, Chicago, San Francisco, Osaka, Dallas & Shanghai, according to BofA Global Research.

Hence, we believe that the Magnificent 7 stocks are trading at a rich valuation. Their average P/E is at a high of 37.4x, disproportionate when compared to their 26% EPS growth of next year. This rich valuation could make the Magnificent 7 stocks vulnerable to a near-term pullback.

Trend Exhaustion

My AI models are signalling a potential exhaustion within the Magnificent 7 stocks, and a bottoming for the Dragon 7 stocks.

Hence, this could be a pivotal moment for investors to dip into this generational pair trade between US and Chinese equities.

One catalyst for such a trade could come from the rising bond yields. Already, we have witnessed the 30bps rise of 10-year bond yields since the start of February.

A breakout of 10-year bond yields above 4.2% could result in a move to the 5% handle, and trigger a correction for the richly-valued US Tech stocks.

Another catalyst could come from heightened geopolitical tensions. In 2024, violence is the new virus where the Red Sea of violence is killing people in war-torn areas such as Ukraine, Gaza, Syria, Lebanon, and Yemen. Further geopolitical tensions could result in a risk-off situation for the US equities.

In conclusion, as we embark upon the new Chinese New Year, the "long China, short US" pair trade stands as a rare opportunity. While uncertainties abound, the extreme valuation differential presents a compelling low-risk opportunity for investors.

This Dragon Year could see the Dragon 7 stocks roar again!

Happy Chinese New Year!