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China "On Fire!" How High will this Market Rise?

|Includes: Renren Inc. (RENN), YOKU
China is cheap right now. Yes, we have known that for some time. In fact, the price-earnings ratio of the Shanghai Composite Index is valued at only 12.9 times estimated earnings. That's a very cheap valuation for companies riding China's seemingly endless growth curve. Over the past four years the average has been closer to 19.

Finally, in the past ten days, Chinese shares have gone from being cheap to something much more attractive. Chinese stocks are "on fire" according to one report from Yahoo Finance.

Leading the charge were Chinese social networking stocks, up more than 20 percent as a group. China's own Facebook, Renren (NYSE:RENN), gained 45 percent over the week. But results like that are a bit of a fluke. Renren bounced only after a huge drop following its IPO.

Meanwhile, Youku (NYSE:YOKU), China's version of YouTube, jumped after the company announced it had partnered with Warner Bros. to offer U.S. video-on-demand to Chinese internet users.

Those may be today's hot names in China, but much more important is the trend among mainstream industries.

As you can see below, the Shanghai Composite Index is rebounding substantially after a weak first half.

Shanghai Composite Index, One Month

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As I predicted last week, Chinese stocks have indeed begun a sustained move, based on some key market-movers.

Most important, is the potential easing of tight money policies. China's Vice Premier, Wang Qishan, signaled a shift when he urged the country's lenders to increase financing to small companies that are having problems raising funds. Small and medium enterprises in China's industrial south are starving for cash. If Beijing successfully opens the spigots, the results could be life-saving.

A Slowdown Boosts Market Confidence

The last thing that America wants is a slowdown in its economic indicators. But in China, too-high growth figures mean rising inflation. And that in turn results in more economic tightening from Beijing.

China's central bank has raised interest rates four times and bank reserve ratios twelve times and since the start of last year in an effort to tame inflation.

But the latest indication that this tightening trend will moderate is a new figure called the non-manufacturing PMI. This purchasing managers' index slowed from a sky-high 61.9 in May to 57, a big drop of almost five points. (Any figure above 50 indicates growth.)

It's not the most famous indicator being watched in China but it did move stock markets on Monday. The non-manufacturing PMI is based on data from twenty industries including real estate, transport, retail, catering and software.

While America was celebrating the Fourth of July, traders in Shanghai were enjoying a celebration of their own. The Shanghai Composite Index jumped 1.76 percent to rise above the 2800 mark with energy and financial companies among the biggest one-day gainers.

Increasing volume in Shanghai may indicate that more investors are coming back into the market. Daily A-share turnover in Shanghai exceeded 100 billion yuan last week, the first time we've seen that kind of money flow since April.

A Thirty Percent Jump?

Now, I'm suddenly hearing a lot of major global brokerages getting on the bandwagon. Standard Chartered's leading analyst told Bloomberg,

"China's stocks are the "most attractive" globally and investors should buy more of the nation's equities as the government achieves a "soft landing" for the economy."

And, Nomura of Japan says:

"Chinese stocks will offer "buying opportunities" in the second half as valuations have already factored in monetary policy tightening amid "less aggressive" interest-rate increases."

Other Asian brokerages, including Citic, CIC and Shenyin & Wanguo Securities say the Shanghai Composite Index is due for a serious second half rally. How big a rally?

CITIC Securities, China's biggest brokerage, has announced a six-month target of 3500 for the Shanghai index. That's a rally of about 30 percent from current levels!

Shenyin & Wanguo Securities says a pessimistic market has priced-in the worst, and signs that overheating is easing signals a turnaround.

Even the worst pessimist about China's market, economist Nouriel Roubini is on board. True, Roubini still expects a "hard landing" for the Chinese economy in 2013. But for the time being he expects growth to continue at a moderate 8.8 percent.

One last note, other Asian Indexes are also showing optimism. In particular, Hong Kong's Hang Seng Index enjoyed a bounce of almost two percent on the July Fourth holiday. Macau casino stocks were among the big gainers in that market as gaming revenues rose again.

Other big gainers in Shanghai were metals producers and auto makers. There is considerable speculation that Beijing will bring out new measures to end the slump in auto buying. Gold miners also enjoyed big gains.

I'll close with the words of the chief equity strategist for London-based Standard Chartered. In the Bloomberg interview he declared:

"The China market is the most promising market among the major markets in the world."

I say Shanghai is already fulfilling that promise.

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