One of the biggest cheerleaders for Chinese stocks just called the top

Lu Yong of China reacts after a missed attempt during the men's 85kg weightlifting event at the 16th Asian Games in Guangzhou, Guangdong province, November 17, 2010REUTERS/Mick TsikasChinese stock prices are getting too much for the bank

One of the biggest cheerleaders for investing in China just hit the Red Dragon with a downgrade.

Morgan Stanley’s Jonathan F Garner and his Asia/Pacific team have downgraded the MSCI China stock exchange to equal weight after almost seven and a half years of betting it will outperform.

In a note sent out today the team said: “It is probably fair to say that we are known in the market for being bullish China — some might say perma bulls — so for us this is a big call.”

The bank’s argument is pretty simple – a rally in Chinese shares since last year means companies are now overvalued and could disappoint with future earnings. The unlocking of Chinese stock markets to outside investors in December has led to an inflow of foreign cash that has boosted values.

Since November the MSCI China Index Fund, which invests in Chinese companies, has jumped 44%, although it has tapered off recently.

Here’s Morgan Stanley:

China’s dramatic recent outperformance has driven a deterioration in absolute and relative valuations and a worsening technically overbought situation. There has not as yet been an improvement in underlying macro-economic performance, thought that may still come, whilst year-on-year earnings per share growth and earnings revisions breadth are also failing to improve.

Morgan Stanley prefers Taiwan, upgrading the country to overweight. The bank today also downgraded Russia to underweight.

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