Crisis Committee and risk analysis

There are two main messages that I find interesting in President’s Basescu conclusions after today’s high level meeting.

First, the President is sending a cautionary message and warns against electoral slippage in government spending.

“Fac o invitatie politicoasa catre toate partidele, in special cele din arcul guvernamental: sa nu alunece in populism”

Second, well the President falls himself into the populism trap. He goes on and as every politician claims that there is no crisis just a reaction to bad economic decisions in US and EU.  Even more he ventures into the land of prediction and claims that in the following days the equity markets will bounce back.

Nu asistăm la o criză, ci la o reacţie a burselor la deciziile neconvingătoare din SUA şi Europa. Probabil că în zilele următoare se va confirma aprecierea făcută şi bursele vor relua creşterea”, a declarat preşedintele Traian Băsescu la sfârşitul întâlnirii de lucru avute astăzi la Palatul Cotroceni.

While the first conclusion I find sensible the second merits at least a theoretical analysis. What the president  is referring to is reversion to the mean. Traders use different names for this statistical phenomenon: what goes up must come down, overvalued/undervalued etc. But history has another example of a President fooled by overrelience on regression to the mean: President Hoover.

In 1930 Hoover declared that “Prosperity is just around the corner” and he was not trying to fool the public. He meant it as history supported his view. Unfortunately production fell in US in 1930 by 9.3% and in 1931 by 8.6%.  The lowest point was reached in 1932 when US GDP has fallen by 55% from its 1929 peak.

And history is littered with such examples. This does not mean that reversion to the mean does not happen but as Keynes put it “as living beings, we are forced to act…” and thus making rule of thumb unstable.

I guess the conclusion here is that one has to be flexible enough and understand that reversion to the mean is just a tool . And sometimes, as investors say, the market can go against you longer than you can stay solvent.

The markets might clam down in a day or two. But after that they can very well correct back to higher levels or continue their move down. Sometimes is just too hard to tell and we should leave it to that.

 

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