he forest and the trees - Can you tell the difference?

While it is well-nigh impossible to call market peaks and troughs perfectly, it is possible to know when one is near the top or the bottom, and adjust accordingly.

As a financial planner, I am not a believer in overly aggressive tactical asset allocation. As long as one's strategic asset allocation is appropriate for a given financial need, tactical adjustments should be used sparingly as they often have the effect of causing investors to be out of the market on good days, and in it on bad ones. The key is to distinguish between volatility and cycles. To continually tinker with asset allocation in a volatile market is a futile exercise. However, to make strategic adjustments in order to cope with a secular change in market direction is essential. The trick is to distinguish between short-term noise and fundamental change!

Generally speaking, the difference between the two categories is their potential to affect the real economy. Markets ultimately reflect the well-being of the economic environment in which listed companies operate, and so it is important to understand whether a phenomenon has a fundamental impact or not.

Risks with no long-lasting impact

*The sub-prime credit crunch. The immediate impact of this crisis is that many NINJA (no income, no jobs or assets) borrowers will lose their homes and that some reckless lenders will go under. While this is bad for the US housing market, its only real global impact was nervousness about the extent of banks' exposure to derivatives based on sub-prime credit. In time, it will turn out to be a healthy development, by weeding out the imprudent and reminding us all that risk should be priced appropriately.

*A US slowdown. America has a remarkably resilient economy, which adjusts quickly to macro-economic shifts. Furthermore, the emergence of the BRICs (Brazil, Russia, India and China) and Europe's recent recovery means that the world economy is now less dependent on American consumer spending.

*An emerging market stampede. In 1997-98, emerging markets were characterised by huge fiscal and current-account deficits, weak currencies and low foreign exchange reserves. Nowadays, they have stable economies and huge forex reserves, and market jitters will have a smaller and less pronounced effect.

Risks that could derail the market

*Stagflation. Oil and war form a dangerous cocktail. The bear market of the 1970s was largely caused by slow global growth and high inflation due to the Arab fuel boycott of the West in the wake of the Yom Kippur War. The current tensions in the Middle East, coupled to anti-American sentiments in countries like Venezuela, Russia and Sudan, could potentially lead to a repeat performance.

*The China syndrome. Much of the media coverage of China is focused on its remarkable growth and development. Less well understood is the inequality and social unrest among its people, the risk of over-investment and its overheated stock market. Should China stumble politically and or economically, it will have dire consequences for all of us.

*Earnings growth peaking. The real economy also moves in cycles. After a long consumer-driven growth phase, companies reach a stage where they operate at full tilt, and need to invest in additional capacity. This tends to coincide with a peaking of earnings, and weaker cash flows over the medium term. If this happens to a lot of companies simultaneously, it could depress equity markets for some years.