Thinking fast and slow about valuations

The world recently learned of the passing of Daniel Kahneman, the psychologist who revolutionised economics, along with Amos Tversky and other collaborators.

He was awarded the economics Nobel Prize in 2002 for his studies on decision-making. He showed that, unlike the traditional models of very rational economic actors, humans are prone to making systemic judgement errors. People are biased in how they make decisions; they make the same mistakes repeatedly, across time and cultural context. This is not merely a matter of emotions – such as fear and greed – getting in the way. These biases consistently creep in due to the use of mental shortcuts and compartmentalisation. It is just the way our brains are wired.

Kahneman and his peers spawned the field of behavioural economics, and its investment-related offshoot, behavioural finance. This work is by now well known, and many good summaries of this field are available, including Kahneman’s most well-known book, Thinking Fast and Slow. Much has also been written about Kahneman’s life and work, so we don’t need to expand on it further here.

Rather, we can ask if there is anything behavioural economics can tell us about the current investment landscape.

One of the biggest cognitive mistakes people make – even highly paid professionals – is to extrapolate from recent trends, arguing that what has gone up, must keep going up.

To be clear, some trends don’t reverse. We get older every day, for instance. Consumer prices tend to rise over time (inflation), though the speed varies from year to year. But most economic processes have some mean reversion tendencies. Strong demand for a particular item tends to encourage higher supply. Excess profits invite competition. Very low prices attract bargain-hunters. The law of diminishing marginal returns applies in production and consumption. Booms are followed by busts, etc. In other words, when one economic variable moves strongly in relation to another, it usually invites some form of reversal.

American exceptionalism
So, let’s turn to perhaps the biggest question equity investors must grapple with. US equities have outperformed the rest of the world since the Global Financial Crisis. How long can this trend persist? This is not a trivial matter since US equities today account for 60% to 70% of global equity benchmarks. A related question is whether the underperformance of South African equities against the rest of the world (especially the world) will continue.

Chart 1: US vs. non-US equities in dollars

Source: LSEG Datastream

Click here to read more...