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  WorldGlobal Strategy 
12 November 2009
Popular
Delusions
 
Knowing what you don
t know: random thoughts on value, volatility and inflation
Dylan Grice
(44) 20 7762 5872dylan.grice@sgcib.com
IMPORTANT: PLEASE READDISCLOSURES AND DISCLAIMERSBEGINNING ON PAGE 9
www.sgresearch.socgen.com
Although few predicted it, we “know” the Berlin Wall was destined to fall with hindsight. Yetwhen it did, it was triggered by events which were unpredictable even with the samehindsight. Our governments look insolvent. Historically this has caused inflation and fundingcrises. But as with predicting the demise of communism in the East, who knows when? Withgovernment bonds overvalued and inflation expectations “generous” it feels wrong that riskassets and volatility trade around their historical averages.
 
“The corrupt and brutal regime of President Ceausescu of Romania was infamous acrossthe world. His ferocious government had run the country emphatically for many years,crushing any signs of dissent ruthlessly. In November 1989 he was re-elected President for  another five years as his supporters at Party Conference gave him forty standing ovations.
 
On December 21st the President, disturbed by a small uprising in the western city of Timisoara in support of a Protestant Clergyman, was persuaded to address the public rally inBucharest.
 
One solitary man in the crowd, Nica Leon, sick to death with Ceausescu and the dreadful circumstances he created for everyone started shouting in favour of the revolutionaries inTimisoara. The crowd around him, obedient to the last, thought that when he shouted out “long live Timisoara!” it was some new political slogan.
 
They started chanting it too. It was only when he called, “Down with Ceausescu!” that they realized something wasn’t quite right. Terrified, they tried to force themselves away from him, dropping the banners they had been carrying. In the crush the wooden batons onwhich the banners were held began to snap underfoot and women started screaming. Theensuing panic sounded like booing.
 
The unthinkable was happening. Ceausescu stood there on his balcony, ludicrously frozen in uncertainty, his mouth opening and shutting. Even the official camera shook with fright.Then the head of security walked swiftly across the balcony towards him and whispered,“They’re getting in”. It was clearly audible on the open microphone and was broadcast over the whole country on live national radio.
 
This was the start of the revolution. Within a week Ceausescu was dead”.
Jon Snow of the BBC, quoted in
Wall and Piece
by Banksy
 
Popular Delusions
12 November 20092
Inevitable randomness
Watching some of the documentaries over the weekend marking the 20
th
anniversary of thefall of the Berlin Wall, I found myself marvelling over and over at the extent to which arguablypredictable events can have unequivocally random triggers. I say arguably predictablebecause, although most commentators were completely caught out by the sudden demise ofhitherto steadfast communist regimes, a minority understood exactly why they would one dayfall. But no one could possibly have known when.Proving that economists don
t have a monopoly on cringeworthy predictions, Ceausescufamously said weeks before he was toppled that democratic reforms would occur in Romaniaonly when pears grew on apple trees. Presumably he attached a probability of zero to theexistence of a Nica Leon.The Berlin Wall itself might even have come down by accident. An announcement on easingrestrictions on East Germans
travelling to West Germany was botched by politburospokesman Gunter Schabowski, who seems not to have properly read his brief. Not knowingwhen the new policy was to come into effect, and pressed by the foreign media during a livebroadcast to give a date, he blurted out
immediately, without delay
. Minutes later anewsreader at ARD in West Germany broadcast that
This 9
th
of November is an historic day.East Germany has announced that, starting immediately, its borders are open to everyone!
 Of course that wasn
t the new policy, and it wasn
t supposed to be effective immediately. Butby then it was too late. The broadcast had been picked up all over East Germany and, withinhours, check points across the border were crowded with hundreds of thousands ofdeliriously ecstatic East Germans celebrating their new-found freedom.Why is this relevant? Consider the following chart summarising market valuations. The redmarks show where we are currently in terms of standard deviations from the historic meanand the lines show the historical ranges.
Nothing to see here: current valuations in historical context – (std deviations from average)
-6-4-202468S&P500 (1881-now)Bonds (1881-now)Credit (1921-now)Volatility (1900-now)
 
Source: SG Global Strategy
 
Popular Delusions
12 November 20093
 At first glance it seems there
s nothing to get excited about. Risk assets
equities and credit
 are on the expensive side of their historical ranges, though hardly egregiously so. But twothings stand out: volatility is right on its average and government bonds are expensive.
Neurological tricks and equity volatility
This subdued volatility makes me nervous. Bloomberg
s Betty Liu interviewing Warren Buffet inearly March remarked that analysts were complaining they couldn
t value their companies inthis
new environment
because no one had any idea what the future held. Even CEOswouldn
t give forecasts because they had no visibility for the rest 2009 or even beyond. Buffetreplied with typical candour:
“Betty, we didn’t have any visibility in 2006 either,
we just thought we did 
… people say “Oh,the future’s too uncertain now” … Well the future was uncertain then, or in 2007 too, they just didn’t know it was uncertain.” 
1
 
This is a fundamental truth. The future is always uncertain. Only the extent of our self-deception changes over time.
 
Nicolas Taleb has famously explained why and how we live withthis delusion and how our cognitive system overrides the role of the random. The Nica Leonsand Gunter Shabowskis of the world are airbrushed out because their existence posesintractable questions. Indeed, the natural state of the mind is to see order even where there isnone, a happy delusional equilibrium tricking us into seeing what can
t be seen.
109 years of variant delusion – DJIA daily volatility
0%10%20%30%40%50%60%70%80%1900 1909 1918 1927 1936 1945 1954 1963 1972 1981 1990 1999 2008
 
Source: SG Global Strategy
 And if equity volatility is a proxy for market visibility, then current equity volatility at its historicalaverage suggests we are in such a delusional equilibrium right now. And thanks to Taleb
sinsights, which teach us that this delusional equilibrium is merely a neurological sleight of handand not based on anything fundamentally
true
, the current confidence exhibited by the
average
level of equity volatility today isn
t based on anything fundamentally true either. It
sbased on the tricks of our collective minds.
1
 
Interview with Bloomberg
s Betty Liu recorded on 5 & 6 March 2009
of 00

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