Stock prices may be right after Chinese selloff

It's been awhile since the stock market went on sale, but investors once again have a choice to make.

Invest in stocks on a strong upward trend but trading at all-time highs, or buy companies whose share prices have just fallen substantially.

Which is more attractive: the momentum or the discount?

That age-old question is being asked in the wake of a significant selloff in Chinese equities. Interestingly, it was the Chinese government that pulled the rug out by announcing a wave of regulations designed to curb the dominance of China's biggest tech companies and flatten the country's economic landscape.

The fallout was steep. In just three trading days from July 22 to July 26, Hong Kong's Hang Seng stock index dropped 11%. At its low, the benchmark was more than 20% below its mid-February high.

With Chinese companies comprising more than one-third of the major Emerging Markets benchmarks, the EM category as a whole also took a hit. The MSCI Emerging Markets Index lost roughly 7 and 15% over the same periods. Investors are left to wonder what's next.

The truth is the authoritarian leanings of China's government make Chinese companies vulnerable to impromptu regulatory crackdowns like we witnessed in July. It's admittedly harder to have confidence in your bet if the rules of the game keep changing.

We disagree.

While the latest changes are a reminder of added uncertainty when investing abroad, it would be unwise to ignore the multitude of reasons why Chinese and Emerging Market equities will bounce back.

First, the U.S. will not retaliate to regulatory changes with an embargo or tariffs. No foreign country supplies more goods to the U.S. than China. A restriction on Chinese imports would disrupt the U.S. economic recovery and reignite a trade war that harmed both countries more than it helped.

Second, China's sheer size brings a big advantage. Despite the obvious risks, portfolio managers (not to mention index funds) with directives to focus on Emerging Markets have few viable alternatives.

As of June 30, Chinese companies accounted for more than 37% of the MSCI index (it was less than 8% in 2005, by the way). In terms of country exposure, the next-largest weightings are Taiwan and South Korea with less than 14% each. China's massive influence on the Emerging Market category all but assures a steady stream of future capital.

As anyone who tracks the S&P 500 knows, buying-the-dip has never been a more popular strategy. That also bodes well for a rebound in Chinese and Emerging Market stocks. The average American investor has far more exposure to U.S. equities than to international ones. This recent selloff opens a window to rebalance. A more aggressive Chinese government creates volatility, but with it comes a potential buying opportunity.