Understanding Cause and Effect: The Implications
One of the main themes at "A Dash" is that expertise is important. When it comes to causal modeling there are two divergent themes in the blogosphere:
- Experts see cause and effect as complex systems. When they see two variables with a high correlation, it is only a starting point. Experts check to see whether both are caused by a third variable (a spurious relationship), the timing of the two (which comes first), and the presence of other intervening variables. We are grossly over-simplifying graduate-level courses in causal modeling, just to give the flavor.
- Amateurs see things in black and white. They see two variables moving in unison and infer causality.
Current Examples Abound
Many issues in the current investment discussion are incorrectly portrayed as "black and white." Here are some examples:
- Short selling. Amateurs see short-selling in financial stocks as a cause. Professionals understand that the ability to sell short is one of many market influences. They understand that short sales are often done against long call options, that they may hedge other positions in pair trades, and that the analysis done by those selling short may expose major problems at specific companies. It is not black and white.
- Accounting. Amateurs see accounting rules like FAS 157 as forcing companies to reveal the truth. Experts know that the securities cited are difficult to value, and that FAS 157 uses a simplistic method. There might not be a single good method, but the pros try to figure it out, not accepting illiquid distressed sales as the ultimate answer.
- Bailouts. The popular media analyzes everything in terms of the potential cost to the taxpayer. That is the theme that sells papers and it is easily understood. The pro considers a more difficult calculation. When do societal effects become so great that it is time to act?
Your Investment Advantage
Many investment pundits embrace a causal chain that ignores government action. They look at events and assume that there cannot be effective intervention. Here is the pattern:
- Things are really bad and government officials do not understand. We are facing the demise of the financial system. Sell your stocks. Buy gold. Buy land in Montana and a few shotguns. Buy complex products that guarantee returns (despite high commissions and high surrender costs). The prediction is that there is no government solution.
- Government acted, but what they are doing is wrong. It is Marxist. It is socialist. It will cost the taxpayer money. You should be upset. And of course, you should still be buying gold.
Briefly put, they were wrong. They underestimated the government response and got burned. They are betting against the US government, and they are not big enough to do that.
Will It Really Work?
No one can know for sure, including us. We wrote that the federal government was too slow in implementing needed changes, including a comprehensive RTC-type solution. Before our pixels were dry, Hank Paulson was there with a proposal.
The market reacted sharply, in the cattle stampede fashion we noted. If you were not already invested, there was little chance to join in.
There is plenty of work to be done. If the Bush Administration and the Congress forge legislation in the time remaining before the election recess, it will be a new record for major legislation — skipping hearings, avoiding filibusters, avoiding extraneous amendments, and acheiving bi-partisan compromise.
It bears watching, but it is not a done deal.