China Is World’s ‘Most Crowded’ Short, Societe Generale Says

China stocks are on the verge of a “massive short squeeze,” Societe Generale SA said, citing recent equity declines, rising short volumes and European restrictions on short sales.

Bets on declining share prices “have been building up over the past six months as hedge funds went short financials,” Todd Martin and Anthony Lee, analysts at Societe Generale, wrote in a report dated today. China is “the world’s most crowded short,” they wrote.

Stocks may rebound as the Shanghai Composite Index is near the “technically important” low of 2,319 reached in July 2010. Shares may also rally as the level of shorts as a percentage of total volume has climbed to 9 percent, while hedge funds have been restricted from shorting stocks in much of Europe, the analysts wrote.

The Hang Seng China Enterprises Index of Chinese stocks available to overseas investors sank 12 percent last week and traded at the lowest level since April 2009 yesterday amid concern Europe’s debt crisis and faltering growth in the U.S. will hurt earnings. The gauge climbed 6.4 percent to 9,294.22 at the 4 p.m. local-time close. The Shanghai Composite has plunged 14 percent this year as the government took steps including raising interest rates to cool inflation.

Dividend Yields

Foreign investors have “lost their sense of reality,” the Societe Generale analysts wrote. The Hang Seng China Enterprises Index trades at 6.28 times 2012 consensus earnings estimates and at a 4.4 percent 2011 dividend yield, compared with U.S. 10-year yields of only 1.88 percent, they wrote.

The MSCI China Financials Index sank 24 percent this month through yesterday, falling more than benchmark bank gauges for Europe, the U.S., Japan and emerging markets. Valuations in China dropped below levels reached during the 2008 global financial crisis for the first time last week, even after Industrial & Commercial Bank of China Ltd. and Bank of China Ltd. said first-half profits hit a record and analysts raised forecasts for next year.

Ping An Insurance Group Co., China’s second-biggest insurance company, is also a “potential short-squeeze candidate” after it denied that major shareholders were pulling out, they wrote. The stock surged 10 percent to HK$46.80 today after plunging 14 percent yesterday amid speculation shareholder HSBC Holdings Plc sold shares.

Short sellers borrow stocks and sell them in the hope of profiting by repurchasing the securities later at a lower price and returning them to the holder. Short-covering occurs when an investor buys a security to close a short position or to return a borrowed security.

In a short squeeze, a lack of supply forces prices upward and traders with short positions are forced to buy securities to cover their positions and limit losses. The surge of buying results in even higher prices.

To contact the reporter on this story: Richard Frost in Hong Kong at rfrost4@bloomberg.net

To contact the editor responsible for this story: Darren Boey at dboey@bloomberg.net

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