* Traders say brokerages, mutual funds start to buy again
* Valuations of Chinese stocks in historical trough
* Reforms spark hopes of a future bull run similar to 2005/07
* Monetary easing, stable economy a must for sustained uptrend
By Lu Jianxin and Pete Sweeney
SHANGHAI, June 13 A period of weakness in Chinese stocks and the economy is luring domestic institutional investors back into the equity market - the activity is small, but follows classic economics of buying low ahead of a possible turn as Beijing ramps up stimulus to shore up growth.
Traders say brokerages, mutual funds and major institutional investors are quietly increasing their exposure to the stock market, which has seen a shattering $1.4 trillion wiped out of the Shanghai and Shenzhen exchanges since October 2007 peak.
The reports follow signs that offshore funds also began quietly increasing their China exposure after Beijing signalled it would begin allowing bond defaults, which some hoped would push money into stocks.
The purchases do not necessarily mean the market has bottomed out, particularly given the recent sharp slowdown in the Chinese economy from its red-hot double-digit growth rates.
All the same, it does suggest a nascent recovery process may be underway, with stock pickers betting on fat profits several years out if the government follows through with its commitment to stop meddling in the stock market and make companies more accountable to shareholders.
In addition, there is the prospect of making quick profits over the near term if the central bank loosens its tight grip on the money supply to shore up the economy which slowed to 18-month lows in the first quarter.
Evidence is mounting that authorities are ramping up their efforts to energise the economy, with fiscal spending shooting up 24 percent on-year in May.
Index heavyweights like property developers and banks have been on the receiving end of a lot of bad news recently. Paradoxically, that is seen as a good time to buy low by some, especially to catch a rebound spurred by possible monetary loosening.
"Evidence is clear that long-term investors have begun building fresh positions; over time, the market may not be as weak as we have seen over the past several years," said Chen Huiqin, senior analyst at Huatai Securities in Nanjing.
"However, a bull run isn't on the horizon yet."
SCARRED FOR LIFE
The average Chinese investor remains on the sidelines, in no small part because they have seen more than $1.4 trillion of value, equivalent to 16 percent of China's gross domestic product in 2013, erased from the Shanghai and Shenzhen exchanges since the SSEC's historical peak of 6,124 points in October 2007.
That has brought the average price/earnings ratio of around 2,500 Chinese listed firms to less than 10 times historic earnings, from more than 70 times in 2007, exchange data show.
"If you're a long-term investor and plan to keep shares on hand for two or three years, it makes sense for you to build positions gradually now because of reasonable valuations," a manager at a Chinese mutual fund said on condition of anonymity because Chinese rules bar fund managers from talking to the media.
Citing record low valuations, Qiao Yongyuan, analyst at Guotai Junan Securities in Shanghai, forecast that the market could rise by as much as 20 percent by the end of 2014.
However, short-term surges based on monetary easing expectations have occurred in the past, without gaining long-term traction.
That leaves reform as the major remaining inducement. The previous market bull run from 2005 to 2007, during which the index rose six-fold, was propelled by government reforms.
But so far this time the suggestion of reforms in the pipeline has not inspired China's retail investors -- who dominate the domestic market -- to jump back in. The CSI300 Index which tracks the largest listed firms in Shanghai and Shenzhen, is down 12.5 percent so far in 2014.
Many of the reforms, while positive, have been incremental technical tweaks.
In fact, some policy changes have chilled investor demand.
The refining of rules for initial public offerings and the unfreezing of the IPO pipeline this year has depressed the market, because retail investors worry that more IPOs will simply dilute net valuations if more money doesn't flow into stocks as a class.
At the same time, despite committing to reducing its role in the market, the China Securities Regulatory Commission (CSRC) has kept a firm hand on the wheel.
Indeed, many investment strategies still hinge on government monetary intervention, rather than underlying market-driven demand for shares.
"China's stock market is still very much liquidity-driven, so unless liquidity conditions improve significantly with a bank reserve requirement ratio cut, an uptrend can't easily be established," said the fund manager at the mutual fund.
($1 = 6.25 Yuan) (Editing by Shri Navaratnam)