Unexpectedly strong earnings at listed Chinese companies have spurred analysts to raise their profit forecasts, creating room for about a 15% rise in Shanghai's benchmark stock index over the next three months.

The upbeat earnings, fed by China's steady economic recovery, are restoring optimism in the stock market after last quarter's gloom, but the rally could be derailed if the government moves more quickly than expected to tighten monetary policy.

"It's very clear that corporate earnings, propelled by the economy's recovery, are now improving much more quickly than the market had expected," said Wu Xiong, research manager at Orient Securities in Shanghai. "Investors could now adjust their investment strategy and take a much more optimistic approach."

Mainland-listed firms' combined net profit rose 26% in the third quarter from a year earlier, leading analysts to boost their forecasts for 2009 Chinese corporate earnings growth to 20% from a flat performance forecast just two months ago.

That cut the average forecast price/earnings ratio of stocks. The 12-month forward P/E ratio on Shanghai A-shares stands at 18.3 as of November, down from 22.6 in August and well below the all-time high of 35.1 hit in 2007 during the market's bubble peak, data from Thomson Reuters I/B/E/S shows.

The lower PEs, considered reasonable given China's growth potential, give China's benchmark Shanghai Composite Index room to rally in the coming three months or so by around 15% from its current level.

That would see the index breach its 2009 high of 3,478 points in early 2010, eight fund managers, analysts and economists surveyed by Reuters this week said.

In a previous survey in early September, Orient Securities' Wu and the others proposed a defensive investment strategy, partly because of high stock valuations.

The market has staged several good-sized technical corrections since August, however, that have trimmed valuations.

The index closed on Thursday at 3,155 points, up more than 70% since the start of the year but down 9% from the year's peak hit in early August.

Yuan appreciation

China's nearly 1,700 listed firms ended their third-quarter results reporting season last weekend with a combined quarterly net profit of 290 billion yuan (USD 42 billion).

Analysts now expect a big fourth-quarter profit rise, especially given a very low base of just 37 billion yuan a year earlier, when listed firms took large provisions and destocking was at its peak as the global financial crisis dampened demand.