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China stock surge so crazy...it just might keep going

·Editor in Chief

The U.S. stock market has been in a fairly tight trading range this year and pretty much has gone sideways, with Tuesday's slide bringing the S&P back to within 2% of break-even for 2015. It's been a very different story in China, where stocks have been on a tremendous winning streak.

The Shanghai Composite is up 175% in the past year while the small-cap Shenzen Composite is up 140% and has more than doubled year-to-date as of Tuesday's close. The Chinese market entered Wednesday's session on a torrid six-day winning streak, which notably occurred as the U.S. market suffered through one of the quietest weeks in recent memory, punctuated by Tuesday's post-holiday sell-off.

After peaking in 2007, Chinese stocks struggled for several years, lagging the S&P 500 and other major Asian markets from 2010-2013. With China's economic growth slowing into single-digit territory, many prognosticators declared the China boom over. But those expecting a "hard landing" in China have been left waiting. Those short stocks have been steamrolled by a rally that began in earnest in mid-2014 when state-run media outlets published a series of articles and television specials that encouraged individuals to invest in stocks.

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"The official Xinhua News Agency published at least eight articles this week advocating equity investing after similar stories appeared in the People's Daily newspaper and on state-run television last month," The Sydney Morning Herald reported at the time, citing articles with headlines such as "China needs a bull market with quality" and "How could the stock market be invigorated?"
The media push coincided with efforts from Chinese regulators to dampen speculation in real estate while simultaneously encouraging trading in stocks, such as cutting margin requirements and reducing fees to open equity accounts.

Then in October 2014 came the opening of the so-called "through train" between China and Hong Kong, which opened the floodgates for foreigners to invest in China's A-shares market -- or at least removed some of the obstacles previously in place. Local investors bid up Chinese stocks in anticipation of the opening of the Shanghai-Hong Kong Stock Connect, a rally which in turn fueled more speculation as investors chased stocks higher once the link officially opened.

"Economic in growth in China has actually declined since the link went live so the major catalyst for this doubling in the value of Chinese stocks was undoubtedly a PE expansion cycle driven by the surge in inbound liquidity that was easy to foresee," writes Josh Brown of Ritholtz Wealth Management.
"The gains, however, were not easy to foresee. Buying into Chinese stocks (or even the Hong Kong-listed stocks like those of the FXI ETF) was far from a no-brainer at the time. Concerns about the banking sector, the shadow-banking complex and the state of the slowing economy offered plenty of reasons to stay away."

Indeed, the presumed experts on China were overly pessimistic in their forecasting of the Chinese stock market: A year ago, the consensus forecast was for gains of just 28%, Bloomberg reports. "Analysts have been scrambling ever since, updating predictions, then re-updating them and re-re-updating them as stocks blew by their target prices. The rally that outran their forecasts is now making their jobs even more difficult as they try to assess the prospects of companies trading at multi-year highs with the possibility of further government stimulus."

What was true during the U.S. dot.com and real estate bubbles is true in China: momentum begets momentum. Forbes contributor Johan Nylander has compiled a list of some of the "crazy facts" about China's stock market, including that more than 10 million new stock accounts have opened so far this year, more than the total number for all of 2012 and 2013 combined.

As for the valuation expansion cycle Brown cited, it's worth noting the Shanghai Composite currently trades with a trailing PE of 21, which is up dramatically from the 2014 low but still less than half the peak it hit in late 2007, according to Jon Najarian of OptionMonster.

Chinese regulators certainly can take steps to dampen the fire if they so choose, but the bottom line is this: the Chinese market isn't wildly expensive, at least not by historical standards, and isn't that much more expensive than the good-old S&P 500.

Aaron Task is Editor-at-Large of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at atask@yahoo-inc.com.

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