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Last month, we looked at a prediction that the Shanghai Composite stock market index was about to crash. The forecast was made by a team lead by the econophysicist Didier Sornette at the Swiss Federal Institute of Technology in Zurich, who has made a study of economic bubbles and how they burst.

His thinking is that bubbles are the result of some kind of feedback mechanism that creates faster-than-exponential growth. This kind of growth rate is straightforward to measure, and so bubbles should be easy to identify.

In July, he and his buddies pointed out that the Shanghai Composite stock market index was following exactly this kind of trend. But they also made an extraordinary prediction. They said that this bubble would burst between July 17 and 27.

That’s a very specific prediction of the kind that economists almost never make. How they came to their conclusion wasn’t clear, and I, for one, was very skeptical. In fact, I bet he was wrong and promised him an arXivblog T-shirt and baseball cap if the market proved otherwise.

So I kept an eye on the index, and on July 27 noted that it was still going strong. In fact, between July 17 and 27, the index rose by 251 points, or about 8 percent. So much for the crash.

Then something strange happened. On August 4, the market hit a peak of 3,471, and then it dropped. Dramatically. By August 19. it had fallen to 2,786, a drop of about 20 percent.

Several questions come to mind. Is this the fall that Sornette and company were predicting or just a coincidence, a regression to the mean? And if the fall is related to their prediction, could the drop have been caused by it?

There’s no way of knowing, really. But it’s too close to Sornette’s original prediction to be ignored. If he has found a way to predict (or trigger) crashes of one kind or another, then it’s hard to underestimate the significance of such a breakthrough. We’ll certainly see other examples, and he and his team may be set to become very rich.

The truth is likely to be more complex. As for the bet, I think I’ll cede him a partial victory in the form of an arXivblog cap.

Ref: arxiv.org/abs/0907.1827: The Chinese Equity Bubble: Ready to Burst

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