(Not) forecasting tastes

The "slump" in share prices reminds me of a curious correlation - the strong link in recent years between equity returns and US economic growth. 
I say "curious" because this link shouldn't exist. Markets should see recessions coming and mark down share prices in advance of them; how hard can it be to just (pdf) look at the yield curve? So why should shares fall during recessions?
Yesterday's big price falls add to this puzzle. The papers say these were triggered by news of Citigroup's troubles.  But this won't do. Any fool could tell weeks ago that banks had yet to annouce the full losses on mortgage securities. And the dividend cut was anticipated long ago.
Nor is it plausible that the drop in December's US retail sales should come as a huge surprise.  The real surprise about retail sales is how strong they've been recently given the weakness of the housing market - up 5.2 per cent excluding autos albeit in nominal terms in the last 12 months. In this context, December's fall, as James says, is only mildly disappointing.
So, why should the market have fallen so much yesterday, and be so sensitive to contemporaneous moves in industrial output?
It can't be solely because American investors and especially equity analysts have an optimism bias that blinds them to the possibility of earnings shortfalls or recession. My chart shows that strong economic growth in the late 90s and in 2004-05 was as good for shares as weak growth was bad.
So, here's my theory. Investors are terrible at is predicting their future tastes; see this great paper (pdf).  They might - or at least should - be able to forecast economic  upswings and downswings. What they don't foresee is the impact these will have upon their appetite for risk. They don't see that bad economic times will cut their appetite for risk and that good times will raise it. The upshot is that shares fall in bad times even if such times should be foreseeable.
There's a lesson here beyond the triviality of short-term market moves. If people are bad at predicting their future tastes, even when billions of pounds are at stake, doesn't this suggest that our ability to make choices that make us happy might be severely limited?

Comments

[reason]

No the reason is subtler than that. People overestimate their own abilities. They think they are smarter than other people and that other people won't forsee changes in GDP. Of course this becomes self-fulfilling.

[Ironman]

There is also the issue of people putting more trust into the accuracy of economic data than they should. I would however point to rational maximization of utility as a significant contributing factor to this phenomenon.

People will continue doing the things that make them happy for as long as possible, much like a teenage party at a friend's house going on right up until the last minute before the parents come home. In the stock market, the fun lasts until someone starts actually cutting their dividends, instead of just talking about it.

Like teenagers again, no one minds so much when that odd one in the corner does it, but they freak out when it's the football hero.

Speaking of correlations between equities and the economy - see the following link for a neat one!

http://tinyurl.com/yu8soo

[kinglear]

.. which is why the best investors are contrarian - the property stocks all shot up yesterday, just when it was announced how bad commercial property had been over the last year

[kio]

I guess that investors should "anchor their expectations" like the Fed proposes for inflation. See Figure 15 at the bottom of my text. It shows no possibility of any investor to really drive the stock market in the long run
http://inflationusa.blogspot.com/2007/08/exact-prediction-of-sp500-at-various.html .
The future of aggregate stock market indices (as well as economies expressed in monetary units) is very well predetermined.

[reason]

Wonderful timing. How do you explain 21.01.2008?