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China's Coming Bull Market. Who Will the Winners Be?

|Includes:VanEck Vectors ChinaAMC CSI 300 ETF (PEK), PTR
Frustrated? As a dedicated China stock-watcher how could I not be?

Over the past year China's economy has dramatically outperformed the U.S. And, Chinese corporations have raked in record profits. But Chinese stock markets have remained annoyingly stagnant.

At the same time, U.S. companies that sell into China have boomed. So why has China itself lagged behind, and when will it soar?

Shanghai Composite Index: One-Year Performance

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Over the past year the Shanghai Composite Index has spiked above the psychologically important 3,000 mark three times, only to fall back sharply. Now we are hitting that 3,000 point again but this time there are indications that a bull run may be on the horizon.

China's housing bubble was at the heart of last year's malaise. An enormous rush of China's money supply was flowing into housing speculation from savings accounts, bank loans, and from volatile stock investment accounts.

Like any bubble, China's housing stampede grew and fed upon itself. Beijing had no choice but to get tough if it wanted to avoid a U.S. style implosion.

Clampdowns on housing speculation weren't enough to rein in that bubble. As runaway inflation loomed, China's central bank brought in the heavy artillery: repeated interest rate hikes.

Each rate hike and every boost in bank reserve ratios gave the markets another shock. Monthly increases in inflation further heightened fears that even more interest rate increases were coming.

But, finally, the interest rate pressure on Chinese stocks appears to be easing.

Double-Digit Gains Predicted

Suddenly, some of the world's biggest investment banks are trumpeting the potential of China-based stocks and indexes.

Credit Suisse is now predicting a flat out bull run for Chinese stock indexes. The investment bank says that's because 2010 profits for leading Chinese companies exceeded expectations. Profits for the 1,400 mainland Chinese companies which had reported results by the end of March were up 38 percent. Sales were 34 percent higher than the year before.

For companies on the MSCI China Index, 2010 earnings were up 30 percent! That's 12 percent more than Credit Suisse said it had expected per-share profits to rise.

As a result of these better-than expected profits, Credit Suisse is predicting some big moves in the indexes which track Chinese stocks. Here they are:

  • The Hang Seng China Enterprises index should rise by a stunning 29 percent. The Hong Kong-listed ETF (HK 2828) tracks this index and can be purchased through most brokerages.

  • The MSCI China Index should also rise by an impressive 27 percent. For investors, BlackRock, Inc. has just announced the listing of the iShares MSCI China Index Fund (NYSE:MCHI). Black Rock claims it is the first ETF to be benchmarked to the large cap and mid cap MSCI universe.

  • Credit Suisse also predicts that Shanghai's yuan-denominated index of class A shares will jump by 17 percent. Shanghai's A share market is off-limits to foreigners except through ETFs. Van Eck's China ETF (NYSE:PEK) seeks to replicate the performance of the CSI 300 Index. The CSI benchmark consists of 300 A-Shares stocks listed in the Shenzhen and Shanghai.

Bulls at Deutsche Bank beat Credit Suisse to the punch, predicting several days earlier that Chinese shares would spike by 25 percent.

Goldman Sachs also upgraded Chinese stocks from "overweight" to "market weight."

Goldman hasn't changed its outlook for the Hang Seng Index but does recommend investment in Chinese banks and property developers, two sectors which it expects to perform the best.

What's Behind the China Craze?

Surprisingly, many analysts say it was last week's interest rate jump which changed everything. Goldman Sachs and other investment giants believe that the worst is over in terms of interest rate hikes.

Goldman says that China is close to the end of its interest rate tightening cycle but Credit Suisse believes there are still more interest rate increases to come.

Credit Suisse says that Chinese stocks are simply undervalued after turning in those sterling 2010 profit reports. Bloomberg says the Hang Seng's price-earnings ratio is now 19 percent below its five-year average.

What's more, the gauge of Chinese companies listed in Hong Kong is valued at just 13 times earnings. That's one very cheap P/E multiple for big caps in the world's fastest growing major economy.

Not everyone agrees. Some say Chinese inflation may continue to cloud the interest rate picture. Those who are calling for caution suggest buying call options to limit risk when investing in China.

But it's looking more closely at some of China's biggest firms which have reported giant profit increases without being rewarded by the market. They include Industrial & Commercial Bank of China (HK: 1398) which increased per-share earnings 29 percent from a year earlier. PetroChina (NYSE:PTR), the country's biggest oil producer, reports that 2010 profit jumped by 36 percent. But, as you can see from the chart below, PetroChina's stock is still waiting for a rise that matches its stellar earnings performance.

PetroChina One Year Performance

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If Credit Suisse and Deutsche Bank are right, China's big caps could be on the brink of a bull run. Stay tuned, and…

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