* Shanghai, Shenzhen stocks plunge 5 percent as bears rule
* Sudden drop in China hits Asia shares 2nd time in 3 days
* Commodities, Australian dollar drop on equity weakness
* Chinese banks on tap to report results
By Kevin Plumberg
HONG KONG, Aug 19 (Reuters) - Chinese shares slumped 5 percent on Wednesday and the rest of Asia and Europe followed on growing fears that global investors were pulling the plug on a 6-month rally amid doubts about a global economic recovery.
Shanghai stocks <.SSEC> tumbled to a two-month low on disappointment that authorities were not taking steps to support the market amid increasingly heavy losses.
A heady run-up in Chinese stocks this year has become firmly linked with global investors' desire to take on more risks again for higher returns. The sharp reversal in China has badly shaken confidence, even though some form of correction had been widely expected after share prices ran up so fast.
European stocks <.FTEU3> fell 1 percent in early trade
while U.S stock futures
Oil and metal prices and cyclical currencies like the Australian dollar also fell as the selloff in China gained pace.
Shanghai shares slumped as much as 5 percent at one point before settling 4.3 percent lower, taking their losses to around 20 percent in just two weeks -- meeting the definition of a bear market.
Even with the latest reversal, the Shanghai index is still up some 53 percent so far this year.
Many international investors had hoped China would lead a global recovery as its economy picked up steam again. While its recovery trend looks intact, signs abound that consumer demand and company profits in the rest of the world remain weak, impeding a broad recovery.
"I'm keen not to get on the wrong side of a correction at this point," said Andrew Orchard, strategist with Royal Bank of Scotland in Hong Kong.
"The conditions for a longer-term bull run are still in place, after all this whole rally has been about liquidity. But I think some valuations look overstretched."
The MSCI index of Asia Pacific stocks outside Japan slipped 0.3 percent after being higher most of the day. The materials sector, which has led the rally in regional markets, was one of the biggest decliners.
Japan's Nikkei share average <.N225> finished 0.8 percent lower, hurt by Shanghai's decline and weakness in retailers and technology stocks, but Sanyo Electric <6764.T> surged as much as 17 percent after a source said it would sell batteries for hybrid cars to Toyota. [.T]
POLICY DISAPPOINTMENT
China's three most influential official securities newspapers published bullish comments on Wednesday seeking to talk up the stock market.
Short-term trading signals on Chinese stocks have moved swiftly from reflecting overbought conditions 12 trading days ago to now being slightly oversold. Still, the correction in valuations may have further to run.
"Investors are disappointed that regulators failed to take any concrete steps to support the market, while sentiment is extremely shaky after the market's tumble over the past two weeks," said analyst Chen Huiqin at Huatai Securities in Nanjing.
Bank of Communications <3328.HK><601328.SS>, the country's fifth-largest lender, will kick off Chinese bank first-half results on Wednesday, followed by two of the world's biggest banks by market value later in the week: Industrial and Commercial Bank of China <1398.HK><601398.SS> and China Construction Bank <0939.HK><601939.SS>.
Pressure on net interest margins is expected to hurt the banks' results despite barely receiving a scratch from the global credit crisis.
The Australian dollar still remained largely shackled to the whims of Chinese stocks, given the strengthening trade ties between the countries.
The Australian dollar dropped 0.4 percent in choppy trade
to US$0.8232
The U.S. dollar got a boost from the Chinese market's weakness after a small dip overnight as Wall Street recovered. The ICE Futures U.S. dollar index <.DXY> rose 0.3 percent.
Three-month copper traded
U.S. crude oil for September delivery fell by 0.4 percent
to $68.93 a barrel
U.S. stock markets rose around 1 percent overnight, rebounding from sharp losses on Monday, as better-than-expected results from big retailers encouraged investors to get back into the market. [.N]
But analysts remain worried about laclustre consumer demand. Many firms which have beat or met market expectations this earnings season have done so by cutting costs, not by increasing sales. (Additional reporting by Claire Zhang and Edmund Klamann in SHANGHAI) (Editing by Kim Coghill)