In the world of finance, the most dangerous thing is the thing that never moves

Han K Lee, 15 Jun 2014

One important lesson learned from 40 years’ share market experience is the importance of psychology in the behaviour of the market. Robert Schiller, last year’s Economics Nobel Laureate, notes that investors can often show ‘irrational exuberance’: “People still place too much confidence and have too strong a belief that paying attention to the gyrations in their investments will someday make them rich, and so they do not make conservative preparations for possible bad outcomes.”

Investors must be wary of feeling too good and too confident about recent strength in equities, and investment managers must not compromise on quality, as we are in an unusual period of artificial stability. What is kept artificially stable is often the most risky. It is like the turkey analogy: a turkey that is fed regularly in the run up to Christmas turns out to be the least safe bird of all.

In the world of finance, the most dangerous thing is the thing that never moves – until it moves.

In the case of China, the stability or appreciation of the RMB has been a great global stabiliser that has made so many other variables more foreseeable. If that great stability goes, then there will be a massive increase in global macro uncertainty and volatility.

The key question facing US policymakers will be how to stimulate the economy and lower the real rate of employment (approximately 47 million Americans are recipients of food stamps), while avoiding another financial crisis caused by asset price inflation and a misallocation of credit.

On the local market valuations are stretched and investors should not be too confident from riding the momentum upwards. The yield play has diminished and the economy is transitioning away from the mining sector.

In this kind of environment, it is prudent to adopt a more defensive and conservative stance by focusing on quality issues. Meaning good companies with strong earnings, strong growth, solid management, at a reasonable price. Investors must be rationally sceptical, rather than irrationally exuberant.