Cyclical markets, rationality and urbanization

Good judges, and the yield curve, reckon there's a good chance of a US recession. This chart shows one reason why this matters - in recent years, there's been a close correlation between industrial production and the S&P 500.
This is surprising. Common sense says markets should see recessions coming, so share prices should discount them in advance.
So why don't they?  One possibility is just that people are rubbish forecasters. Another is that investors do see recessions coming, but fail to see the impact this will have in reducing their appetite for risk.
Whatever, it suggests many investors make systematic errors of judgment - either in forecasting the economy or their own tastes. They hold onto shares as the economy approaches recession, even though the recession cuts share prices. And they sell shares before a stronger economy raises prices.
This bears upon this argument between Jim and Anthony about urbanization. Millions of people move out of the countryside into cities, even though conditions in those cities are appalling. What should we make of this?
Jim says it shows that  millions of people make wrong choices.  Anthony says we shouldn't impute stupidity to the poor.
But couldn't they both be right?  If rich, educated people fail to anticipate economic fluctuations or future tastes, and so (on average) make mistaken decisions about their financial investments, isn't it likely that poor, uneducated ones can also make wrong decisions about their human capital investments? So, chalk one up to Jim.
But both rich and poor are  systematically wrong. So the poor aren't especially stupid. Chalk one up to Anthony.

Comments

[Jim]

"Jim says it shows that millions of people make wrong choices."

Kind of, but it's more subtle than that. Millions of people end up in appalling conditions in cities because (a) that may be the better of two bad choices, or perhaps they had no choice at all, perhaps due to being chucked off their land, and/or (b) they make choices which in retrospect they might wish they hadn't either because they made the wrong choice or because circumstances changed.

[Piyush]

The behaviour of the economy in the future is primarily a function of the aggregate behaviours of people ( rich, poor and of all other classifications). It isn't wholly surprising that whilst an intelligent ( and/or rich) person may be better at predicting his own future behavioural patterns, he is no better equipped to model the aggregate behaviour of the crowd - which is what determines economic cycles.
There is some evidence ( The wisdom of crowds theory) that large groups collectively make accurate decisions though but the conditions have to be right. It would be interesting to see the results if someone put up a poll on a site visited by a range of informed and uninformed people ( BBC news for instance) and asked a question - "What value do you think the FTSE will be at in June 2008?". There is some evidence to suggest that the average of the crowd's prediction will probably be better than any individual in forecasting the correct value.

[chris]

Jim - I agree entirely. I merely picked upon the "wrong" decision aspect to maintain focus.
Piyush - I agree in general about the wisdom of crowds. But there is evidence from happiness research that people are bad at predicting changes in their future tastes; this might help explain why share prices are more volatile than they "should" be.

[Piyush]

Isn't "people are bad at predicting X" simply another way of saying X is unpredictable ?
I know data-dredging ( would have inserted a wikipedia link here if typepad allowed it ) can always throw up instances in the past where some data relationships could have been exploited to make predictions but somehow research like this is always susceptible to data snooping bias.

I prefer the simple version of your statement - changes in future tastes are unpredictable !

[dearieme]

IF equity markets are dominated by professional investors, and IF their livelihoods depend on relative (not absolute) performance, then they are most at risk when they are "out of the market". So they tend not to replace equity by cash or bonds. Any merit in this argument?

[Piyush]

Surely if people could foresee a coming recession and a fall in the equity markets, the rational strategy would , as you say, would be to move to cash en masse. You could argue that the increased cash in the economy as a result should act to boost consumption head off the recession which would cause investors as a group to get back into equities again. Basically, if all investors acted rationally as a group, the recession they had predicted rationally and acted rationally to avoid would not occur hence making them 'bad' at forecasting !

[tom s.]

I'm glad that in the comments Jim restated his original claim, which allowed that many people move into cities not because it's a choice, but because they are kicked off their land. You just need to read Making of the English Working Class to see the original in action.

But, to maintain Chris's focus on the decision aspect - there is another possibility, although I don't know enough about 3rd world urbanization to know if it applies in this case. This is that (a) they made good choices in going to the city, but (b) they are worse off there anyway.

As soon as externalities exist, you can't assume that good choices lead to good results. If, for example [and off the top of my head], it requires a critical mass of population to sustain some form of public goods in rural areas, then migration to the cities may happen, but may leave people in the worst of two equilibria.

[John Thacker]

Of course, while situations in cities are often appalling for the poor, merely because there's a higher percentage chance of having bad thing X occur does not mean that it's a bad decision anyway.

1) They may think that they can work their way up and initially be worse off in return for being better off later.

2) They may be willing to trade a worse median result in exchange for a higher expected value result, or otherwise they may be indifferent between two fairly poor alternatives but greatly value the idea of striking it rich.

3) They may value things available in the cities, like culture and exciting opportunities, that are outside of things measured by the HIV/AIDS rate.

Categories 1, 2, and 3 certainly occur to some degree. Otherwise all artists and grad students are being stupid as well.

[tom s.]

your point being?....