Since Anthony Bolton launched his much-hyped China fund three months ago, shares on the Shanghai stock market have tumbled more than 20 per cent – a plunge that has put the index firmly in the grip of a bear market.

The celebrated British fund manager, though, is unfazed – and not only because most of the Chinese companies in his portfolio are listed on the Hong Kong stock exchange or other offshore bourses.

Mr Bolton reckons the Shanghai Composite will stage a sharp recovery this year and that the pessimism gripping mainland investors is only one of several signs that now is the moment to buy.

“As a contrarian, [the weak sentiment] is all very good news to me,” he says. “That suggests that it's not a time to be cautious, it's a time to be optimistic.”

Many investors are waiting for steeper falls before they dip their toes in again. Yet, strategists in increasing numbers are calling the bottom of a market that has lost almost a third of its value since its peak in August 2009.

Mainland Chinese equities have always operated in a world of their own, almost entirely cut off from international investors because of China's strict capital controls.

As a result, Shanghai's booms and busts have less to do with what investors believe are companies' fundamental valuations and more to do with speculation and liquidity – the amount of money flowing through the financial system.

Indeed, Shanghai stocks surged 80 per cent last year as Chinese state-owned banks – including Agricultural Bank of China, which makes its debut on the Hong Kong stock exchange today – hosed down the economy with Rmb9,600bn ($1,400bn) in new loans.

One reason why shares have fallen since then is that the government, worried that the economy is overheating, has sought to slow the pace of credit expansion and launched a crackdown on debt-fuelled property speculation. Not only have Chinese A-shares deflated sharply in price, but daily turnover on mainland stock exchanges has slumped by about 40 per cent from its year-to-date average, says Macquarie.

“Domestic investors appear wary of being caught in a long, flat bottom – leaving them reluctant to substantially build equity stakes,” says Michael Kurtz, China strategist at Macquarie.

Mr Kurtz has now turned bullish on the Shanghai market. Some valuation measures now support a more positive stance. A-shares were yesterday trading at a multiple of about 14 times estimated 2010 earnings – a 30 per cent discount to the average over the past five years, according to Bloomberg data. To put that in context, New York's S&P 500 is trading on a 2010 price-to- earnings multiple of about 13, while London's FTSE 100 is on a multiple of about 11.

While the Shanghai Composite's price-to-earnings ratio fell to as low as 12 during the November 2008 trough, another dip to that level is unlikely, Mr Kurtz argues, since China's economy is now healthier than it was during the depths of the financial crisis.

Unlike in 2008, when A shares were battered by turmoil in overseas markets, investors' chief concern regards Chinese government policy on domestic inflation.

According to official figures yesterday, China's year-on-year economic growth slowed to 10.3 per cent in the second quarter, down from 11.9 per cent in the first quarter – showing that government efforts to rein in inflation were having an effect. The slowdown appears to have blunted the recent surge in prices. Year-on-year inflation fell from 3.1 per cent in May, to 2.9 per cent in June.

“The economic data show that China's economy has well and truly cooled down and that inflation has possibly peaked,” says Shane Oliver, head of investment strategy at AMP Capital Investors in Sydney.

Although not everyone agrees that inflation is on a downward path, there is nevertheless widespread belief that the Chinese government will now opt to loosen policy – or at least to slow the pace of tightening – in coming months.

Such a decision could involve approving more infrastructure and investment projects, boosting the overall credit quota, or removing some of the property market restrictions that have already caused home sales to slump amid expectations of a 20-30 per cent crash in prices. It could give equities a shot in the arm.

International investors are already more bullish about China than mainland investors. The most common way for foreign investors to access mainland Chinese stocks is by the Hong Kong-listed iShares A50 China tracker, an exchange-traded fund that follows the performance of the 50 largest A-share companies. The A50 ETF was yesterday trading at a 10.5 per cent premium to its net asset value – far higher than the average premium since 2004 of about 2 per cent.

Also, for the first time in more than three years, the gap between the share prices of Chinese companies dual-listed in Shanghai and Hong Kong disappeared last month. A shares traded in Shanghai have traditionally sold at a wide premium to their H share counterparts traded in Hong Kong.

Bulls reckon the stars have aligned. Valuation metrics, they argue, suggest there will be limited downside to Shanghai's market in the year's second half.

But gains are far from guaranteed. Apart from the risk of a double-dip recession in the west and an escalation of the eurozone debt crisis – both of which could undermine share prices worldwide – one scenario few investors appear to have considered is stagflation: when growth slows more rapidly than expected at the same time as inflation accelerates.

Mr Bolton, for his part, thinks that unlikely. If there is consensus among fund managers, he may be closer to it than he would like to admit.