Their evidence was that the index had been growing at a faster
than exponential rate, which was clearly measurable and obviously
unsustainable. But Sornette and co were less forthcoming about how
they were able to say a collapse was imminent. I was sceptical of
this prediction and said so.
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And yet at the beginning of August, the Shanghai Composite dropped
by about 20 per cent and I was forced to eat my words, puzzled though
I still was to their method.
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Today, Sornette and co publish the method they use to make their
prediction. Their method is a synthesis of ideas from the economic
theory of rational expectation bubbles, from the imitation and
herding behaviour of investors and traders and from the mathematical
and statistical physics of bifurcations and phase transitions.
From this, they say they have discovered an unambiguous signature
of a bubble market about to collapse in the form of super-exponential
growth decorated with logarithmic oscillations as in the diagram
above.
Sornette says he has used this method to predict the collapse of
several bubbles in the last few years, including the collapse of the
oil bubble last year and the US housing market in 2006.
That’s important work which could have a profound impact on
economic models. If Sornette and his colleagues have put their money
where there mouths are, they ought to be super rich by now.
One interesting aspect of Sornette’s predictions is that the team
claim that they will not affect the market in a way that changes the
forecast.
“Even in the presence of investors fully informed of
the presence of the bubble and with the knowledge of its end date, it
remains rational to stay invested in the market to garner very large
returns since the risk of a crash remains finite.”
Of course, the end of a bubble doesn’t always imply a crash, just
a change from super exponential growth to some other kind of market
dynamics.
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But if Sornette’s forecasts prove reliable, the herding behaviour
of traders and investors makes it seem inevitable that they will
trigger crashes. If that happens, they will become self-fulfilling
prophecies that will generate some interesting dilemmas for traders
and regulators alike.
Ref: arxiv.org/abs/0909.1007: Bubble Diagnosis and Prediction of the 2005-2007 and 2008-2009 Chinese stock market bubbles