EVERY DECADE OR two, clever people predict the demise of America and the inevitable ascendancy of a new, greater economic power. Remember Japan in the 1980s? Of late, the elephant in the room is another Asian tiger: China. The frenzy surrounding the Beijing Olympics only fanned the exuberance and contributed to the great rush into Chinese stocks.

But alas, that tiger is looking more like a ponderous panda these days. The Dow Jones China Offshore 50 Index, which measures the 50 largest Chinese stocks traded overseas, fell to a new 52-week low on Tuesday. It's lost 45% since peaking in October 2007. The Dow Jones Shanghai Index, which tracks stocks on the Shanghai Stock Market, is down 55% year to date after roaring ahead 164% in 2007.

Portfolios geared at U.S. investors aren't faring much better. The Matthews China mutual fund and iShares FTSE/Xinhua China 25 Index exchange-traded fund are both down about 30% year to date, illustrating the perils of investing in single-country funds. Those who followed the hot money into China's stock market a year ago near the peak are finding out why conventional wisdom warns against chasing returns.

"A year and a half ago there was huge sentiment that the [Chinese] market was going to run until the Olympics and then you needed to watch out. It ran so fast that people started saying maybe we've gotten carried away with China," says Allan Nichols, editor of Morningstar's International Investor newsletter. "The selling started feeding on itself and now there's just this huge pullback."

Surely there was reason to get giddy over China, considering all the infrastructure investment pouring into Beijing ahead of the summer games. UBS issued a research note in September 2007 pointing out that in the past, the local stock markets of host countries do well during the Olympic year as well as the year prior and after. "If history repeats itself, investors are likely to see positive stock market returns in China from 2007-09," the UBS analysts said. They did caution, of course, that "macro factors and market valuation might be different."

That's turning out true today, with China's 6% inflation rate threatening heretofore strong corporate profits. In addition, as much as China likes to tout the new openness of its economy, the government still has a heavy hand in the market. The country's energy woes are a case in point: Government price controls made it unprofitable for utilities to increase power generation. That's in turn constrained China's power-hungry industrial sector, which has been behind its growth.

If you're sitting on a pile of depreciated China holdings, we wouldn't necessarily sell now at a steep loss. Chinese stocks are bound to regain momentum. But going forward, the best bet for investors who believe in Beijing's prospects is to wade into the markets in small increments rather than diving in all at once, Nichols advises.

"Long term it's still a wonderful story. It's a question of timing. You don't want to jump in all at once and get sucked into the euphoria," Nichols says. "You have to pay attention to fundamentals and valuation, because it's a market that can get pretty overheated. If you overpay, it doesn't matter how good the story is."

Also See:
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