Chinese stocks are deep in a bear market, but one market watcher spies an entry point

The threat of an all-out trade war with the U.S. has taken an axe to Chinese stocks over the summer.

The Shanghai Composite and U.S.-traded FXI large-cap China ETF tumbled more than 20 percent from their January highs, pulling both into a bear market.

One market watcher sees more pain to come, but also spies an opportunity amid the wreckage.

"We're setting up for a spectacular capitulation in the China shares," Larry McDonald, editor of the Bear Traps Report, said on CNBC's "Trading Nation" on Thursday. "We're going to have a nice washout, I think, within two weeks."

Trade tensions, a major headwind, could ratchet even higher in coming weeks as President Donald Trump floats a proposal for 25 percent tariffs on $200 billion in Chinese goods. That marks a significant escalation from the $34 billion that went into effect at the beginning of July.

Also putting the squeeze on Chinese markets is a U.S. dollar on the rise and the Federal Reserve's plans to continue tightening monetary policy, says McDonald.

"The Federal Reserve is going to $50 billion a month of balance sheet reduction in September. At the same time they're hiking rates, the dollar made a 7 percent vicious move higher," he said, also noting that China's banking system, at $45 trillion, is highly leveraged to the U.S.

"As the Fed's trying to unwind, it's creating this early stages of a recession in China and it's going to come into a fantastic opportunity in the next 30 days or so," said McDonald. He plans to buy the FXI ETF at the height of capitulation.

Piper Jaffray's chief market technician Craig Johnson says more pressure on the Chinese markets could trigger a wave of sell-offs, particularly if the Shanghai Composite breaks below a major level of support.

"Right now we're very close to violating the uptrend support line that's been intact since 1996," Johnson told CNBC's "Trading Nation." "A break below this level is going to suggest that the next support could be 27 percent lower than where we are now."

A 27 percent drop from current levels puts the Shanghai at around 2,020, a level not seen in four years.

Downside pressure also spells trouble for U.S. markets given their tight correlation with Chinese markets, says Johnson. The Shanghai Composite and S&P 500 had a positive correlation of 0.68 on a 40-week rolling basis.

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Don’t Consider Price When Looking to Buy Cheap Stocks

A critical ability in succeeding in stock market investing involves understanding the concept of a “cheap stock.” Mastering this idea requires more than finding the lowest share price. Making money by buying cheap stocks involves not only understanding a stock’s price, it also means knowing what that price buys.

Cheap Stocks and Normal Stock Prices

The most critical concept investors need to understand is that price means very little. Suppose a company’s stock sells at $10 per share. By looking only at a price, the buyer only knows that one share costs $10. Price conveys no information on the number of shares outstanding, revenues, profits, long-term debt, or plant and equipment.

A company can also manipulate a stock price. In theory, a company could employ a 2:1 stock split. This changes nothing except that a company has twice as many shares at half of the previous value. What good is buying a share at half of its previous price if it holds 50% less value?

Start With Valuation

Thus, rather than trying to look for cheap stocks based purely on price, investors should seek “undervalued” stocks. However, investors sometimes find “undervalued” difficult to define. Most commonly, investors use the price-earnings (P/E) ratio. Like the name implies the P/E ratio divides the price of the stock by its annual earnings.

However, if a company loses money, it will not have a P/E ratio. In those cases, investors may use the price-to-sales (PS) ratio, a comparison of the company’s value to its revenues.

They may also employ the price-to-book (PB) ratio. The PB ratio compares the stock-based value of the company with the stockholders’ equity on the balance sheet.

Going back to the P/E ratio, if XYZ company trades for $10 per share and earns $1 per share in profit for the year, its P/E ratio would be 10. If a stock worth $10 per share earns $1 per share, this implies a 10% profit yield. Most investors would consider 10% an adequate rate of return.

Moreover, the average S&P 500 P/E ratio between 1957 and 2017 stands at about 18.6. Hence on the surface, a P/E ratio of 10 might appear undervalued.

Approach P/E Ratios Carefully

That said, a favorable P/E ratio may not necessarily serve as an indication to buy a stock. Those who look at enough stocks may continue to bid the stock price of Amazon (NASDAQ:AMZN) higher even though its P/E exceeds 200. They also might sell off stock in Ford (NYSE:F) even when it trades below six times earnings.

Such disparities often occur when stocks see different rates of profit growth. For this reason, many evaluate stocks by their price-to-earnings-to-growth (PEG) ratio. The average PEG ratio stands at around 1.33. From the previous example, if our $10 per share stock grew its profits at 10% per year, that would imply a PEG ratio of 1.

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While a low PEG ratio may appear to serve as a buy signal, knowing both the company and the industry also remains critical. Even with steady growth, conditions such as high debt levels, geopolitical events, labor disputes, severe weather events, or other occurrences can change a stock’s valuation perspective.

This makes valuation as much art as it is science. However, with the high liquidity and research options regarding stocks, investors can employ multiple options to manage such risks.

The Bottom Line on Cheap Stocks

Finding cheap stocks means understanding what the price of a stock buys in terms of value. Both the number of shares of a stock and its price starts out at arbitrary levels.

Hence, investors do not find cheap stocks by finding the lowest share prices. Comparing prices to earnings (or sometimes sales or stockholders’ equity) serves as a better measure. Investors also need to consider growth and other factors besides P/E ratios.

However, the focus needs to rest on value not price. By understanding the true nature of cheap stocks, investors can avoid paying the high cost of low-priced stocks and instead, earn higher returns.

As of this writing, Will Healy did not hold a position in any of the aforementioned stocks. You can follow Will on Twitter