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Causality and Patterns   (February 22, 2007)

A question from astute reader V.N. alerted me to the potential for confusion between causation and pattern in the Pareto Principle. V.N. asked what I was proposing as the causal mechanism behind my proposition that 4% of mortgages entering delinquency could trigger widespread declines in 64% of the housing market.

My answer: I wasn't suggesting a causal mechanism as much as a pattern of Nature which may apply to housing as it does to income distribution, etc. Thus we cannot say that 2 million of the outstanding 50 million mortgages turning sour will necessarily trigger a widespread decline; we can only be alert to the possibility that the housing market will follow patterns such as the 20/80 and 4/64 rule.

In a similar fashion, we can look at these two charts of stock market history and note some eerily prescient correlations between then and now:

In all three cases--1929-1936, 1966-1973, and 2000-2007--a multi-decade market high was followed by a precipitous decline and an ensuing 7-year recovery--at which point another precipitous decline occurred. As you know, the global stock markets hit euphoric highs in March 2000, and now we find ourselves just days away from March 2007. The Nikkei has just reached 18,000 for the first time in seven years, the Dow Jones continues to hit new historic highs, and so on.

Could the next "unexpected" sharp decline in global stock markets be just around the corner? We can't say what might cause such a wealth-crushing drop, but we can note the similarities to patterns which have recurred in the past.

For more on this subject and a wide array of other topics, please visit my weblog.


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