This article was carried in the
economic times on 2nd august
Chances are you have never heard of Didier Sornette. Chances
are that the next time you hear of him, you will be significantly poorer –
unless you listen to what he says now!
Sornette is Professor of Entrepreneurial Risks at the Swiss
Federal Institute of Technology (ETH Zurich). His research focuses of the
prediction of crisis and extreme events in complex systems. His work covers earthquake
physics, dynamics of success on social networks, and complex system approach to
medicine. However, the part that attracts market attention is what he does at
the Financial Crisis Observatory – which is – to test the hypothesis that
financial “bubbles” can be diagnosed in real time and their termination
predicted probabilistically. In other words, he attempts to find when the next
big fall in the financial markets can occur.
The term “bubble” refers to a situation where excessive
future expectations lead to rise in prices. Sornette identifies speculative
bubbles as arising from a confluence of two factors – factors that drive
initial demand – say, new technology, or perception of reduced market risk.
This is followed by “amplification mechanisms”, where large increase in asset price
is followed by higher demand as investor think that further large increases in
price will follow. This “super-exponential” acceleration in prices due to a
positive feedback (or “pro-cyclicality”) leads to formation and then maturation
of a bubble in finite time.
In other words when expectations of growth rate itself grow,
it leads to instability. Recent examples have been the crash of 2008, and the
technology burst in 2000, among others. In Sornette’s world, the cause of the
crash is unimportant. His research suggests that crashes have an internal
origin – the unrealistic rise in expectations – and external factors only serve
as catalyst for the subsequent burst. So why is all this important?
Of Black Swans...
In 2001, Nassim Nicholas Taleb, quantitative trader and
academician published a book “Fooled by Randomness” where he outlined the
theory of “Black Swans”. Taleb described “Black Swans” as events whose
probability of occurrence was mathematically very low (like finding a black
swan in a bevy of white swans). Taleb explained that these events occur with
higher frequency than theory predicted, were hard-to-predict if not impossible
to predict, and caused events of significant consequence and magnitude.
... and Dragon Kings
Sornette, on the other hand, makes an entirely contrary
claim. Not only can he predict the probability of a bubble bursting, he can do
it with remarkable accuracy and of course, before the event! He calls these
“outlier events” as Dragon Kings. The
graphs below show the predictions of the S&P500 US Index, and oil prices –
made before the crash in 2007-2008. Similar other graphs can be found on the
website of his Financial Crisis Observatory.
A matter of modelling
The broad basis of the prediction is based on “power law”. Most
models of market prices use the “normal” distribution to model price behaviour.
This model underestimates risk. Studies suggest that a better model, especially
when markets are leveraged – which they often are – is to apply the power law.
Sornette’s model looks for “out-of-control” growth in asset
price that vary from the power law. “When herding behaviour among investor’s
ramps up, a stock’s or index’s growth rate can increase faster than
exponentially, leading to more herding. This positive feedback brings the system
to a tipping point. About two-thirds of the time, a crash results”, says
Sornette in a paper in 2009.
To break away from allegations that his forecasts are
self-fulfilling – after all, market participants who believe his forecasts are
likely to start positioning themselves accordingly, Sornette’s team now makes
forecast which are released in encrypted form on a website with a public key to
decode the paper after the forecast period. . His most recent prediction was a
“”Sell” signal on 21 May 2013 on the S&P500, when his Crash Risk Index
jumped up (see graph). The market was down 9.5% in a month after that.
Sornette recently made a presentation at TEDGlobal 2013 – a
talk worth viewing (http://www.ted.com/talks/didier_sornette_how_we_can_predict_the_next_financial_crisis.html).
The upshot of the presentation and the subsequent interview (http://blog.ted.com/2013/06/17/turbulent-times-ahead-qa-with-economist-didier-sornette/)
is that he continues to foresee bubbles in financial and
insurance sectors, as well as construction and realty sectors in the USA – the
very same sectors that led the burst in 2008 in the first place. Ironically,
the success of a model can also lead to its demise as participants adjust their
behaviour to include the forecasts of the model. Till this happens, Sornette’s
research needs to be taken seriously.
