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So who’s right about China’s stock markets?

Domestic Chinese investors, who follow government pronouncements on bank lending as if they’re portfolios depended on it, have led selling that has taken the Shanghai Stock market down 16% in August.

Wall Street money managers are still calling Chinese stocks undervalued and say they’ll use the pullback as a buying opportunity.

I’d put my money with those who China who understand that the difference between rising and falling stock prices is how much money investors can borrow from China’s banks to buy shares.

The August decline has stopped a rally that sent Shanghai shares up 103% from their November 2008 lows.

That rally was driven by projections that the government’s $590 billion stimulus program had revived economic growth in China, and more importantly, by run-away growth in bank loans. Chinese banks extended a record $1.1 trillion of new loans in the first half of 2009.

(For the possibility that China’s economic recovery is an accounting fiction, see my August 11 post, “Is the speed of China’s economic growth a fiction”

In July, however, the Beijing government, worried that much of this money was going to fuel speculative bubbles in stocks and real estate, reduced loan growth to the lowest level in seven months. The government looks likely to keep loans near current levels and many domestic investors are afraid that the current rate of a mere $40 to $60 billion in new loans a month won’t be enough to push share prices higher.

New York’s money managers have a different take on China’s stocks. They see shares as undervalued because 1) they trade 13% below the analyst consensus price target for the Shanghai market, and because 2) profits are rising faster at Chinese companies than anywhere else in the world.

The valuation argument goes like this: The Standard & Poor’s 500 Stock index is trading just 6% below the analyst consensus target price, according to calculations from Bloomberg. India’s Mumbai stock exchange is now 2.6% above the analyst target.

In fact, the Bloomberg data show, the Shanghai stock market is the cheapest of the world’s 10 largest stock markets when measured against analyst target prices.

That has led New York investors such as Barton Biggs of Traxis Partners to predict a further rally in Chinese stocks.

The profit argument is straight forward. Because the Chinese economy has entered its recovery stage sooner than any other economy in the world, profits at Chinese companies are growing faster than anywhere else in the world. New York Investment bank Morgan Stanley estimates that earnings in China will growth by 15% this year and 20% in 2010. Because of that Morgan Stanley is predicting that prices of Chinese shares will climb by 36% in the next 12 months.

Both these arguments seems specious to me.

First, arguing that Chinese stocks are cheap and therefore a buy because they’re priced below analyst price targets ignores the way that target prices operate. Investors have seen over and over again that analyst price targets lag rather than lead stock markets. Analysts raise target prices the most when stocks are rallying. As those of us who invested through the tech bubble of 1999 and 2000, it’s when stocks are climbing every day that analysts compete to see who can slap the highest target price on AOL or (AMZN) or Google (GOOG). It’s only when stocks have plunged that analysts cut their targets and then they compete to see who can come up with the lowest target for General Motors (GM) or General Electric (GE).

So the “fact” that Shanghai stocks are 13% below analyst target prices after a 103% rally is, well, to put kindly, meaningless.

And the argument about profits? Who really knows what the profits at any of China’s large companies really are?

Take Industrial & Commercial Bank of China (ICBAF), the world’s largest bank by market capitalization. The bank posted higher than expected second quarter profits. But do you think anybody really knows what the bank’s loan portfolio really looks like? China’s banks would still be sitting on bad loans from the 1997 Asian currency crisis except for government-approved accounting magic.

In the long term I think the growth of China’s economy is one of the world’s great investment stories and I think every U.S. investors needs to be exposed to that story.

In the short-term, however, I vote with the cynics in Shanghai.