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Investors in Chinese Stocks Patiently Wait for the Bubble to Pop

It's a myth that when the tech bubble collapsed in 2000, nobody saw it coming. Many on Wall Street were aware of the Buzz Lightyear valuations - to infinity and beyond - but remained convinced that the rally had not yet run its course and that investors could not afford to miss out on the rest of it.

The 80 percent-plus rise of Chinese stocks this year resembles that experience, with many investment professionals expressing concern about the potential for a bubble to form. That is a normally a bullish contrarian indicator; when the consensus among investors is that one thing will happen, it's usually safe to bet the opposite way.

But not always. In practically the same breath as they mention the B word, they affirm their belief that no bubble has formed yet but that investors or the authorities must be on the lookout for signs of one. Some go on to say that while the prospect of a bubble worries them, they remain overweight in Chinese stocks. This recent Bloomberg News story highlights the contradiction.

There are certainly signs that a bubble is near, if not here already. Eric Schurenberg, MoneyWatch's editor-in-chief, addressed the risks of investing in China recently.

Gary Dorsch noted in a post on the Seeking Alpha website that Shanghai stocks have been trading at the extremely rich valuation of 35 times earnings and that smaller companies listed in Shenzhen were recently valued at 45 times earnings.

The latest edition of Global Market Perspective, a newsletter published by Elliott Wave International, offered an example of the Nasdaq-style extremes that have taken hold in China. After its initial public offering late last month, China State Construction Engineering Corp. was worth more than the entire Russian stock market. At its peak, the company was valued at $239 billion, or 53 times earnings.

Despite such absurd numbers - only an analyst who is a character in a Samuel Beckett play would find such a valuation reasonable - the newsletter's editors remain bullish on China, much like the heavily invested pros.

There is something crazy about the rally in China, but it makes sense too. As Robert Arnott, chairman of the Newport Beach, Calif., asset-management firm Research Affiliates, points out, the government stimulus program, much bigger than the one here relative to the size of the economy, is funneling money into stocks. When more money is spent on the same assets, their prices rise.

That explains the run-up, but it doesn't justify it, in his view. Arnott has been cutting his exposure to China, although his concern is less about the potential for a bubble to pop than about a serious impediment to long-term progress that he envisions.

The Chinese population isn't getting any younger. Aging baby boomers and such initiatives as the one-child policy will mean that the ratio of workers to retirees will shrink for many years, slowing economic growth, Arnott told MoneyWatch.

China has become a darling of global investors for the prodigious growth in economic output that it has generated year after year. He expects that rate to slow persistently and markedly, much as it did in Japan, another rapidly aging Asian country, after the 1980s, its time as the world's economic and investment marvel.

Arnott offered no guess on whether China is a bubble ripe for popping. Yet even if it's not, it could be a bubble that will do little good for shareholders as the air is let out slowly and painfully.

"There are risks out there," Arnott warns. "It's easy to focus on the short term and look with envy and delight at the scale of their rally, but it's important to look at the long term. The investment implication is that China will be different in the coming decade from the last one, with steadily slower growth. That's the biggest challenge."

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