Two recent letters in the FT demonstrate how irreconcilable are the two views of the equity return process, as between a random walk with some drift that happens in the past to have been upwards and mean reversion with a meaningful trend that is the product of an equilibrium model for business and the economy. Even without mathematical proof it is necessary to decide which belief system you plan to act consistent with, as even the rejection of the underpinning of an economic model calls into question what else will give any reliable backing to the non-equity assets that are supposedly risk free. My own letter, by focusing on the consequences for those risk free assets of failure of the market system on which mean reversion relies, applies (OK, only loosely) the logic of Pascal’s Wager. ‘With no dependable riskless alternative, a vital requirement for the random walkers, you might as well act as though the process is mean reverting and the system will survive, even if you are not convinced.’
For random walk: Zwi Bodie + John Ralfe
For mean reversion: Andrew Smithers
To settle the argument the Blaise Pascal way: Fowler