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Is China Headed for a Bull Run? Bulls & Bears Fight it Out

I've been watching an all-out war between the China bulls and bears over the past month. The giants of the investing world disagree about the future prospects of Chinese stocks.

UBS is flashing a strong "buy" signal. But the China-hands at Goldman Sachs are warning: don't do it.

Prudential Financial says China is a "buy". Fidelity International agrees. But other China analysts, like Shenyin & Wanguo Securities, say don't bet on it. Whom do we believe?

Well, most of the nay-saying about China is based on fear about the future of the economy. Some pundits worry about an end to China's multi-year, double-digit economic expansion. Others worry about the effects of repeated interest rate rises, as Beijing fights a pitched battle against inflation. Most frightened of all are analysts like Jim Chanos, who has been issuing warnings since last year about a potential real estate implosion.

Let's deal with Chanos first. He's a legendary short-seller. He has never been to China. I believe his predictions of doom don't take into account a host of special circumstances unique to China. Because of Chinese rules governing mortgages, property taxes, bank reserves and property speculation, an American-style real estate implosion is much, much less likely.

Nevertheless, the fear-mongers have cast a pall over Chinese stocks during a period of rapid expansion. And that has created a valuation gap.

As corporate profits in China have boomed, share values simply haven't kept pace.

Comparisons of valuations in Shanghai and Hong Kong by Bloomberg show the gap vividly.

MSCI China Index Six-Month Performance

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The components of the MSCI China Index are selling at dirt-cheap valuations.

The Bloomberg study found that the China Index was trading at only 11.7 times estimated profits for 2011. But the same report found Hong Kong-traded shares selling at much higher valuations.

MSCI Hong Kong Index Six-Month Performance

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While Shanghai stocks were in a slump until recently, Hong Kong shares were increasing in valuation, with a 26 percent rally between July and December. That pushed valuations to 17.5 times earnings.

That's reportedly the biggest gap ever seen between shares on the mainland and those in Hong Kong.

The Bottom Line

Everything is in place for a bull run. If Chinese stocks can rise to match Hong Kong's valuations, that means a jump of more than 50 percent.

But what about those interest rate rises? Could they strangle the recovery? The biggest bear in the arena, Goldman Sachs says there may be short-term setbacks in China. But even Goldman expects China to rebound strongly in the second half of the year. The investment giant says the "super-boom" in BRIC economies is far from over.

FidelityInternational, which oversees a quarter of a trillion dollars in investments, said in January that the first half of the year will be especially strong for China. So far that forecast has been exactly right. Fidelity says inflation in China is definitely "not a showstopper".

The Royal Bank of Scotland is even more bullish. RBS says rising rates suggest robust growth, and rising inflation generally results a hike in earnings as well.

Bulls & Tigers

The biggest bull in the arena is the veteran investor, Barton Briggs. He says most of Asia will be a "tiger" over the rest of the year. The head of the Traxis hedge-fund says China may become the best major market in the world. He credits Beijing's aggressive stimulus during the economic crisis for China's "soft-landing".

In the end, I think it all comes back to valuation. Chinese stocks are cheap and bargains don't last long. As fear of inflation recedes, Chinese companies will be bid up to parity or above.

The last time Chinese stocks were this cheap compared to Hong Kong, according to the Bloomberg study, was in June of 2004. Veteran investors remember what happened next. Chinese shares began a bull run lasting more than three years. The MSCI China Index jumped 500 percent.

Valuations were 12.5 times earning at the start of that bull run. They eventually rose to the dizzying level of 31.

I'm not saying they'll go that high again. But China is definitely undervalued and corporate profits are still rising.

Eventually the bulls are sure to get another good run in China.

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