I say this because of a curious fact - that homebuyers pay more for houses with pools in the summer than they do in the winter. Devin Pope at the University of Chicago and colleagues have estimated that the same house with a pool fetches $1,600 (£1,229.91) more in the summer than it does in the winter.
This is evidence that people are prone to a projection bias: we over-estimate the extent to which our future tastes will resemble our current ones. People pay too much for pools in the summer because they fail to fully anticipate that they won't be as useful in the winter.
Why does this matter for equity investors? Simple. Pretty much all economists expect the economy to slow down sharply soon. (Whether this leads to outright recession or not isn't important: the difference between slight growth and a slight fall in mismeasured data is of significance only to statistical fetishists). Common sense says stock markets should be already pricing this in: the FTSE 250 and small-cap indices have indeed fallen.
However, lower earnings are not the only effect of economic downturns. Slowdowns also reduce investors' appetite for risk with the result that prices fall by even more than earnings. Two things tell us this. One is that recessions see falls in price-earnings ratios: between December 2007 and February 2009 the PE on the All-Share index fell from 12 to just eight. The other is that share prices move by more than one-for-one with changes in economic activity. Since January 1995 each one percentage point variation in annual manufacturing output growth has been associated with a 3.1 percentage point variation in annual returns on the All-Share index.
Which brings me to the problem. The projection bias warns us that investors might not be fully anticipating this. Just as American housebuyers fail to see that swimming pools will be less attractive in the winter so perhaps investors fail to fully anticipate that slower growth will reduce their appetite for risk. If so, the downturn will reduce share prices even though it is widely expected.
This poses the question: how much evidence do we have that the projection bias is widespread?
Plenty. Dr Pope also found that it is true in the car market: people pay more for convertibles in the summer. It’s well known that people who go to supermarkets when they are hungry buy more food than if they’ve just eaten. We all know women who buy shoes and dresses they wear only once, or men who buy DIY tools they rarely use. (For me, it's kitchen equipment.) As Matthew Rabin at the University of Berkeley has said, the projection bias "can cause misguided purchases of durable goods". In fact, two of the best-selling singles of all time expressed this bias: Whitney Houston's "I will always love you" and Celine Dion's "My heart will go on".
We might see the bias in stock markets too. It might explain why equity returns are so seasonal. In the autumn, investors fail to foresee that their mood will improve in the spring and so drive prices down too far, and in the spring they don't foresee that they’ll become gloomy in the autumn and so prices are too high.
I'm not sure rational investors can do much about the projection bias. It's risky to short-sell the whole market when you believe investors are too cheerful simply because they could become even more cheerful before reality breaks upon them. It’s for this reason that equity markets might be, as the late Paul Samuelson said, "macro inefficient". If they are, equity investors should worry.
