Chinese stocks such as SkyPeople Fruit Juices (NYSE: SPU), China Sky One Medical (NASDAQ: CSKI), China Mass Media (NYSE: CMM) and Noah Education Publishings (NYSE: NED) were among the top gainers on Friday; with others such as China Fire & Security (NASDAQ: CFSG) and Yongye International (NASDAQ: YONG) recently attracting private equity money.  Chinese stocks could be recovering from the recent selloff.  Also of significance is that James Chanos, a hedge fund manager and a leading bear on China, stated that he is having difficulty in finding shares to short.

Studies have shown that financial markets are very inefficient in the short term but reasonably efficient in pricing over the long term.  Virtually all Chinese stocks have been pounded as a result of the fraud uncovered at a number of publicly companies.  As a result, the indexes covering Chinese stocks are at major lows.

Much of the price declines are justified from basic economic factors, however, not just from the markets overreacting to cases of fraud.  Inflation in China is high, around 10 percent annually for food.  The real estate sector is in a bubble, downgraded by all three rating agencies due to excessive inventory, low sales and collapsing prices.  Foreign currency traders are taking huge positions against the Yuan, betting that it will collapse in value.

But many major financial players still see China as an excellent investment for the future.  Stephen Roach, head of Asia for Morgan Stanley (NYSE: MS), forsees a stronger, broader economic growth rate of about 7 percent annually for China based on an expanding service economy.  Analysts from the Royal Bank of Scotland (NYSE: RBS) see Chinese stocks rebounding strongly in the second half of the year.

In addition, the Chinese Government is moving forcefully to protect its currency, economy, and financial markets.  Interest rates have been increased three times this year to strengthen the Yuan.  Actions have been taken to clamp down on corporate malfeasence.   With $3 trillion in foreign currency reserves, there is much, much more that Beijing can do to strengthen the economy.

Investors should follow the actions of sophisticated investors to profit from the inefficiencies in the market for the short term pricing of Chinese equities.  As an example, both Bain Capital and the private equity arm of Morgan Stanley made substantial investments in Chinese companies.  Bain Capital invested in China Fire & Security Group (NASDAQ: CFSG) while Morgan Stanley bought into Yongye International (NASDAQ: YONG).  Both stocks rose in share price immediately after the news, but then fell shortly thereafter due to Chinese companies being in disfavor.  Investors can profit from the markets overrreacting in that manner in the short term for these and other Chinese stocks.