Is the market telling us that the growth in China's economy can justify the high valuation of the stocks? Or as former US Federal Reserve chairman Alan Greenspan said, a ""dramatic contraction'' is a distinct prospect? The crowd's collective intelligence is telling us it's the former. But of course, crowds have collectively been very wrong before.

HOW things have changed in the past few years.

With the the burst of the dotcom bubble, 9/11 and Sars, many fund managers were saying investment returns had moved permanently to a lower plane and that the high returns of previous times had gone. Now after two or three years of a solid bull market, a friend told me confidently this week that getting a return of 10 per cent a year is highly achievable.

How we perceive things is a function of our experience, with the most recent history having the greater weight in influencing our opinions. The fact is, the world is getting increasingly complex. A business not only has to compete with existing competitors, it also has to anticipate possible changes in its customers' needs, and look beyond the horizon towards new technologies and challengers that may render it obsolete.

Similarly, investors looking to put money in a stock or company have to assess the sustainability of the business. They also have to contend with the current valuation of that business and the market's preference or disdain for it.

And so many other factors can affect a business or the performance of your investment - interest rates in the US, the movement of yen, the policy of the Chinese government, a sudden increase in the market's risk aversion, and so on. How then do you process all of these moving parts to come to a conclusion to act one way or the other?

Humans apply what economist Herbert Simon called 'bounded rationality'. Bounded rationality means there is too much information for any one person to process, so we simplify to clarify our decisions and find some handles to use to secure a mental grasp.

For example, two people may look out of the same window but notice different things. Each will notice what is personally interesting or important to him. One may notice a young mother playing with her baby. The other's attention may be caught by a yellow Lamborghini parked in the corner.

In his article A Curious Dilemma in CFA Magazine, Wayne Wagner says that applied to the market, this principle suggests that managers and traders focus on a few things they personally consider important - and ignore the rest.

'These decision drivers may be fundamentals, technical signals, supply/demand shifts, and numerous financial variables, ratios and short cuts,' according to Mr Wagner. 'Whatever they are, they are handful in number. That's all the human mind can deal with at one time.'

Which of the elements are most important depends on our past experience. If by focusing on low price-earnings and low price-to-book ratios, you have discovered a couple of very good investments, then going forward you are likely to use these two metrics as the most important criteria when assessing a stock.

This kind of filtering applies to managers and traders, although their choices of decision drivers will differ significantly. The portfolio manager wants to take a long drive, while the trader needs to know how to get the car started (or stopped), says Mr Wagner.

This 'few-variable effect' is evident in statistical models as well. Those who have built regression or stock-selection models would know that after a handful of factors or so, adding additional 'explanatory' variables limits rather than increases the predictive power of the model.

'The net result is that we don't play the real market; rather, we hum along with the song the market sings in our individual heads,' says Mr Wagner. 'At times, our mental model fits well enough. At other times, we're out of tune. And we can't predict whether the next shift will be favourable to our thinking or not.'

Fear, greed and exuberance

For the past few years, the predominant factors in anticipating the performance of a stock have been: exposure to China, ramping of production capacity, or continued increase in selling price - as in the case of property companies.

And so far, the bets have pretty much been one way. This has created an environment where fear is far from many investors' mind.

But as Mr Wagner notes, fear is a necessary factor in the operation of any market. Remove fear, and the markets cannot restrain rampant greed and exuberance. That was what happened in October 1987.

Portfolio insurance, programmed into a computer so that once the portfolio value hit a certain level on the downside, automatically initiated sell orders so portfolio value was protected beyond that 'floor' level.

And as the market went up, the floor was raised and locked in gains. So in effect, portfolio insurance created 'riskless' investments, contorting the greed-fear balance of investors. The scheme was so popular that an estimated 10 per cent of pension assets in the US were 'insured'.

The problem was when there was a fall, everybody would be heading for the exit at the same time. So when an external event trigger caused the market to fall, portfolio insurance managers had to sell equities to fulfill the insurance contract. When they sold, the market dropped further, and when the market dropped, they had to sell more.

The only way to correct the imbalance was for portfolio insurance to default on its guarantee. And this resulted in an unforgettable psychological experience for many investors.

Fred Schwed said in Where are the Customers' Yachts?: 'There are certain things that cannot be adequately explained to a virgin, either by words or pictures. Like all of life's rich emotional experiences, the full flavour of losing important money cannot be conveyed by literature.'

Which is why research has found that the size of an asset bubble is a function of how long it has been since the last crash. The more historically distant the crash, the bigger the next bubble.

Not many of today's investors in China's red-hot stock markets have experienced a major crash, which makes many of them fearless.

But experienced market players can tell you the stock market is one of the most uncertain areas of human endeavour. Nothing is assured and nothing works all the time - not even the best intellects, research and ardour.

For example, many were expecting a severe correction this month, as happened in May last year. Instead, markets around the world have gone on to chalk up new highs day after day.

So, the most motivated and intensive efforts cannot guarantee the desired results. 'We need to apply the best of our science and art, but a few strokes of serendipitous timing always come in handy,' says Mr Wagner.

Even super computers can't process the full complexity of the market, he says.

'Thus traders, especially, need to attune to the ever-changing balance of buyers and sellers. While portfolio managers search for the long trends and hidden values, a trader experiences a brand new market every day.

'A curious dilemma affects managers and traders. Both need the courage of their convictions, yet simultaneously must listen for the market's messages. Perhaps the song our memory is singing in our head is out of tune with what the market reveals. Experience means knowing when to act on the conviction and when to lay low.'

So is the market telling us that the growth in China's economy can justify the high valuation of the stocks? Or as former US Federal Reserve chairman Alan Greenspan said, a 'dramatic contraction' is a distinct prospect?

The crowd's collective intelligence is telling us it's the former. But of course, crowds have collectively been very wrong before. What is happening can be described as 'euphoric people seeing a limitless future, and willing to pay way up for whatever is driving the process'. And on many occasions before, this has had a not-so-happy ending.

The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg.