The real reason equities are not priced for a downturn may not be numerical

This piece was first published on Livewire Markets.

Evan Lucas knows a thing or two about investing. Starting his career during the wash-up of the Global Financial Crisis, he has seen investors make serious money and lose even bigger amounts of it. And while history rarely repeats, it certainly rhymes. New investors who had started their journeys during the depths of the COVID-19 pandemic were smashed with the harsh realisation that stocks don't actually go up forever.

Fast forward to 2023 and those earnings multiples at the index level have started to mellow to historical averages. But some, like Ron Temple of Lazard Asset Management, believe that the de-rate has still not gone far enough. Indeed, it's those investors who believe equities have still not priced in a recession.

Lucas tends to agree, arguing that markets believe the dominant psychology of there being a soft landing and a Goldilocks-style response in equity markets. And nowhere is this more apparent than the ASX consumer discretionary sector.

"The behaviour that has been induced from COVID has been very hard to put in some form of behavioural model," he said. "Spending is still really heavy and that's clearly a behaviour thing. Markets have been picking up on that and the expectation that discretionary stocks like JB Hi-Fi (ASX: JBH), Nick Scali (ASX: NCK), Harvey Norman (ASX: HVN), and Temple and Webster (ASX: TPW) have not fallen through the floor - yet."

In this wire, we're going to take a walk through the land of behavioural economics with the InvestSMART Chief Market Strategist. Lucas is also the author of a new book Mind over Money, designed to help people strengthen their understanding of what money means to them.

Modelling sentiment is next to impossible

As an economics graduate myself (yes, really), I know a thing or two about models. Sometimes, the assumptions are useful but most of the time, they need ripping out and redesigning to fit the situation of the day. 

But how can you model sentiment after COVID - and in particular, the rise of the Reddit/meme trader? Although it's simply unquantifiable hitherto, Lucas argues you can look at demographics for some clues.

The US is looking heavily at cohorting ... and it's the 30-55 year old group that is most interesting. The top echelon of that group has experienced high inflation and high interest rates but the majority haven't," Lucas notes. 

He adds that people on higher incomes will probably end up deciding whether inflation comes down for the simple reason that they have more to spend over a greater period of time.

"The reason they [35-50] are the most important group is because they are the ones with the highest levels of income and are not at retirement change. They are the ones who will likely determine whether inflation is able to move down to target. So far, the behaviour is not enough in that cohort change to possibly be there. The group above them [55+] who have experienced this before are reverting to old behaviours," Lucas says.

But something has definitely changed

To quote the title of a Brooke Fraser song, there's definitely "something in the water". The ASX 200 doesn't just fall 500 points in a month (January 2022) before rebounding by the end of the year to near-all-time highs. Can this be attributed to behaviour too?

"The change will probably be cyclical. My argument is that time heals all," Lucas says. "Markets will end up doing what they do best, which is remembering there are pure fundamentals and that equities are made up of firms that want to improve themselves. The question is, how long does it take to do that."

So where will 2023 go? Lucas argues it's not about inflation anymore - it's about earnings.

"It's already started to show - the markets' next fascination is going to be around how inflation from 2022 starts to come into margins," he says. 

That price everyone bought into over the last couple of years will be questioned. And that is a healthy but short-term thing.

... and it's the way money is perceived

2020 also brought up the rise of buy-now-pay-later services. At its peak, there were at least 10 public BNPL companies. Since the buyout of Afterpay, the largest one by market capitalisation has become Zip Co. It has a net profit margin of -280%. Lucas says the rise of BNPL helped him work out who the book is for - people who want to gain a better sense of what their money can do.

"My big question is "what is money to you?" and everyone I ask has a different answer, so why would you expect personal finance to be all the same?" Lucas says.

For some, the answer is to gain financial independence and retire early (FIRE). For others, it's to provide a future for their children. 

"For me, I think of money as time. I can't stop time but I can gain more of it," Lucas says.

His tips for emotional investors: automate your trades

In the last 10 years, technology has allowed investors to run their own trades in a way that's easier than ever. That brings both positives and negatives, but it also highlights the key question Lucas would pose to investors who are trigger-happy. "Knowing your own behaviour is great but unfortunately, it doesn't fix the problem," Lucas says. "The rise of technology has helped develop the habit you need because of things like automation," he adds.

Lucas says automating your trades could help you stop further losses or initiate a trade that you would not have otherwise done.

"Set it up, get it done, and once it's done, it forces an electronic and possibly personal habit that works out better for you," he says.

Automation is just one of the tools available to investors in 2023 but there are many more behavioural traits to overcome no matter how far you are along your investing journey. 

Combatting loss aversion

The first of these is loss aversion, and this habit falls under both the "bad decision" and "inaction" umbrellas. Lucas admits that this is the hardest habit to overcome, especially if you have held a stock all the way down and are just waiting for a bounce to sell or break-even.

"People would rather avoid some risk for better returns than invest. This over time leads to worse outcomes as inflation eats the value of the uninvested funds," Lucas says. 

One of the ways to avoid this has already been mentioned (automation). The other way of avoiding this pitfall is to think with inflation in mind. Adding real values to your investments, Lucas says, helps investors to realise that inaction is also as problematic as making a bad decision.

Combatting confirmation bias

Another bias is confirmation bias - the idea that you hold a view then read or digest information that reinforces that view without any critical thought. And in the world of social media and Reddit forums, that's easier to fall into than ever. Lucas' tip to overcoming this is simple - argue with yourself.

"What are the pros/cons of the opposite view, could the opposite view be the better answer?" Lucas says. "Although this strategy isn't perfect it will at least make you stop, think, and truly ask yourself - is this my best option or idea?"

Combatting attention bias

Then, there's attention bias which argues that investors get way too caught up on one news event or data point. Lucas says that this is more of a buy-side issue given when you've held a security, you already own it! So what's his tip?

"The way to get around attention bias is to remember the information catching your attention is very small compared to the full information you should have in making an investment decision," Lucas says. 

"Look at the most information that relates to that sector, or space, or idea. Ask yourself what is so attractive about this idea and why has it caught everyone's attention? Most likely its because something has moved very fast and outside its normal operation and that's a red flag," he added.

What keeps Evan up at night (and what gets him up in the morning)

Unsurprisingly, Lucas believes behavioural economics is the most fascinating niche in finance (hence why he wrote the book). But it also explains what keeps him up at night - and what gets him up in the morning.

The thing that keeps me up at night is that we're missing something. COVID's changed and YOLO is real. There is no doubt that has changed investors," Lucas says. 

"Once you take that behaviour genie out, how do you put it back? You don't want to put back the lifestyle you can have in the post-COVID world," he adds. 

Having said this, the fear of the unknown is also the opportunity in Lucas' view.