Image: China © Lawrence Manning, Corbis

If China's stock markets are headed into a major rally, it's time to take a look at what I call "good" China stocks and "bad" China stocks.

It's too early, in my opinion, to be sure that we're going to see one of those explosive 40% to 80% moves off a bottom that China's equity markets deliver from time to time. But I do expect a rally worth buying.

So in this column, I'll give you the names of stocks I'd put in each category -- four "good" stocks and five "bad" stocks. And I'll end with some thoughts on how to use them as this potential rally approaches.

The bounce is on

We have seen a huge drop in the Shanghai Composite Index, which in late September was down 70% from its October 2007 levels, but things are changing. The index bounced off the psychologically important 2,000 level on Sept. 26. -- and the index is up 5.1% from that Sept. 26 low to the Oct. 17 close. (The Shanghai index has trailed Hong Kong's Hang Seng Index, which is up 11.9% from its low on Sept. 5 through Oct. 17.)

China's markets have turned on anticipation -- or hope -- of more aggressive stimulus measures from the Beijing government in the run-up to and the days after the official transfer of power to a new leadership team on Nov. 8 at the 18th Party Congress. That stimulus could be less aggressive than expected, or it could be ineffective. (For more on why this stimulus could be way less effective than the last round, see my column "The world's next big stock rally.")

And it's quite possible that the 7.4% growth rate for the third quarter, announced on Oct. 18, doesn't mark the bottom for China's growth in this cycle.

So we don't know and won't know until we see numbers for growth from the fourth quarter (sometime in the first quarter of 2013) or from the first quarter (sometime in the second quarter of 2013).

Jim Jubak

Jim Jubak

If the current stimulus hopes ultimately end in disappointment, I think we'll see a rally on hope that continues the current move up until the disappointing data arrive late in the fourth quarter early in 2013.

If the stimulus hopes become a real turn in China's economy, and the third quarter of 2012 does turn out to be the bottom for China's economic growth rate, then I think we could see a more restrained version (and slow growth in Europe, China's biggest trading partner) of the traditional explosive rally in Shanghai and Hong Kong. Even if that rally is restrained, it will be worth owning a piece of it. (This, by the way, is my current read. The third-quarter numbers showed a decided pickup in growth in September, the last month of the quarter.)

How to read China stocks

Here's the challenge: China's stocks are notoriously volatile and frighteningly opaque. Many investors are rightly afraid that any Chinese stock they buy will turn out to be a fraud based on creative accounting.

Certainly there have been enough examples of that -- Sino-Forest (SNOFF) and Longtop Financial Technologies come to mind. And even if the company ultimately turns out not to be a fraud, a short-selling attack on a Chinese company stands a good chance of success because so many Chinese companies are opaque and hard to understand.

In response to that truth about the Chinese market, and in order to derive an investing strategy responsive to the unknown potential of what looks to me to be the early stages of a significant rally, I've come to think of China's stocks in two groups: "bad" and "good."

Usually when investors talk about "good" and "bad" stocks, the "good" stocks are those that they'd buy and the "bad" ones are those that they'd shun. Here I mean something slightly different.

"Bad" China stocks are those that you don't want to buy on their fundamentals -- because the fundamentals could be deceptive, misleading or downright fraudulent, and frequently an investor has no hope of knowing the truth. Oddly enough, in the Chinese markets I think these "bad" stocks are frequently those that do best in the early, explosive stages of an anticipation rally like the one that seems to be building now.

"Good" China stocks are those that give investors more certainty that the fundamentals are indeed as advertised -- even if we still can't be entirely certain. These stocks can lag in the early stages of an anticipation rally. But as anticipation of growth turns into real growth, you'd much rather be in this group than holding the early "bad" rockets.

The usefulness of this strategy lies in being able to tell the difference between "good" and "bad" and being able to match that difference to the appropriate stage of the market. You may choose not own "bad" China stocks even during the early stages of a rally -- they are volatile and risky, although that goes along with their tendency to outperform early in the cycle. But you still should learn to recognize the difference, even if it's only so you don't get sucked into buying that "bad" stock when the early owners are starting to sell.

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