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Money Talks

May 19, 2011, 1:52 a.m. EDT

5 money moves one China basher is making now

Small-caps, Europe beat emerging markets, Wall Street veteran Rich Bernstein says

By Jonathan Burton, MarketWatch

SAN FRANCISCO (MarketWatch) — Avoiding the Wall Street herd isn’t good enough for Richard Bernstein; he’s more inclined to mow it down.

Nowadays Bernstein is taking aim at investor favorites, including emerging markets, commodities and gold, with a particular focus on China. Investors don’t want to hear that the bloom is off emerging markets and commodities, Bernstein noted, which only encourages the veteran market strategist to shout louder.

Rich Bernstein.

“China has a credit bubble that makes ours look like nothing,” said Bernstein, CEO of Richard Bernstein Advisors and former chief investment strategist and head of Merrill Lynch’s Investment Strategy Group. “Gold,” he added, “is not in a bubble but it is about as close as you can get.”

Bernstein’s firm manages assets for institutions, but he recently introduced Eaton Vance Richard Bernstein Multi-Market Equity Strategy Fund (NAS:ERBAX)  for retail investors.

The diversified stock fund can invest anywhere in the world, and it’s safe to say that China, emerging markets and any other investment sector that Bernstein believes is overhyped and overbought won’t get his money. When it comes to markets that are unloved and even hated, on the other hand, Bernstein is more likely to write a check.

Here’s Bernstein’s advice about where to put your money, where to pull it, and why:

1. Chinese stocks will underperform

Investing in Chinese stocks, in Bernstein’s view, is an accident that’s not just waiting to happen, but is happening now. Indeed, China-region mutual funds are down 3% on average in the past month, and are flat on the year so far, according to investment researcher Morningstar Inc.

Bernstein said the inflationary pressures that are slowing China’s economic growth could worsen, and pointed out that China is suffering the hangover of a credit binge that exceeds anything seen in the U.S.

“Everything people don’t like about the United States over the past five years they have in spades,” Bernstein said about China. Inflation is derailing business growth and depressing stock prices in India and Brazil as well, he added, but investors don’t want to hear that these problems might not be short-lived.

“People are so worried about inflation in the U.S., but few are talking about it in the emerging markets,” Bernstein said. “Lighten up on China, on India, on BRICs [Brazil, Russia, India, China] in general. Investors don’t realize that many of the emerging markets are showing characteristics of a very late cycle.”

He added: “Everybody looks at the growth, but not what’s causing the growth. If it’s massive credit-induced growth and the central bank is tightening, historically that has meant that there’s trouble ahead.”

2. Commodity prices will drop

Emerging-market headwinds have a direct, negative effect on commodities, Bernstein said. China and other emerging markets, he noted, have been key drivers of global commodities demand — momentum fueled by easy credit.

“Now emerging-market central banks are tightening, and they will likely curtail that excess demand,” Bernstein said. “Commodity prices are likely to fall as a result, which will benefit the U.S. economy. Our cycle is extended because the emerging-market central banks effectively are doing the Federal Reserve’s dirty work — they’re tightening to curtain the excess demand for commodities, so the Fed can stay on hold longer.” Read more: Protect your silver, gold, commodities investments from margin hikes.

3. Gold prices will fall

The danger with gold now is that speculators control the market, Bernstein said, as “gold is not trading on fundamentals.”

There’s a strong case for owning gold when the U.S. dollar is pervasively weak, and dollar-based investors are wise to hedge against a loss of purchasing power, Bernstein said. But contrary to the consensus view, he said, the dollar’s value is not being debased. In fact, he said, the dollar, as measured by the US Dollar Index Future (IFUS:DXY)   has appreciated since April 2008.

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“This is getting nutty,” Bernstein said about the run-up in gold. “A lot of people are sure that the dollar is falling and just refuse to look at the data. If you want to play this, that’s fine, but don’t convince yourself this is fundamentally based.” Read more: Money Talks -- 5 money moves one gold bug is making now.

4. U.S. small-cap stocks will outperform

Investors have been flocking to U.S. stocks — in particular, shares of big companies with a global footprint that seem ready to weather whatever global uncertainty or slowdown comes along.

They’ve got it half-right, Bernstein said.

“Everyone loves large-cap, high-quality dividend paying multinationals,” he said. “We’re not a huge fan.”

U.S. small caps are more attractive than their larger counterparts, Bernstein said, not least because they are the “most-hated equity segment” among investors. “People refuse to invest in small-cap companies,” Bernstein said. “You’ll hear they’re too expensive, and they have no exposure to emerging markets.”

Yet domestic small-caps as a group have a projected growth rate about 50% greater than do Chinese stocks, Bernstein said.

“Our strategy is to have exposure to the U.S. economy and shield ourselves from the emerging markets,” he said. “The fundamentals of the United States are generally improving,” he said, and “small-cap U.S. companies could be the world’s undiscovered growth story.”

5. Europe will exceed investor expectations

Europe’s companies are healthier than its governments, and investors should not equate the two, Bernstein said. To be sure, while the European Union is in turmoil, Europe’s stock markets are intact. Europe stocks, in dollar terms, are ahead of the U.S. benchmark Standard & Poor’s 500 Index (S&P:SPX)  so far this year.

Ask U.S. investors which market has outperformed this year, China or Italy, and most would say China, Bernstein suggested. In fact, Italy is up about 13% so far this year in U.S. dollar terms versus a 1.7% gain for China, according to research firm MSCI.

Bernstein’s Eaton Vance fund sports a number of European stocks in its top 10 holdings, including Roche Holding AG (OTC:RHHVF)  , BP (NYS:BP) , Credit Suisse Group (NYS:CS)  and GDF Suez .

“Equity allocations are probably too underweight Europe,” Bernstein said. ““Clearly something is going on in corporate Europe that people have not anticipated.”

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