Forecasting Financial Crashes: The Ultimate Experiment Begins

Is it really possible to predict the end of financial bubbles? Didier Sornette at the Swiss Federal Institute of Technology in Zurich thinks so and has set up the Financial Crisis Observatory at ETH to study the idea.

We’ve looked at his extraordinary predictions before. Earlier this year, he identified a bubble in the Shanghai Composite Index and much to this blog’s surprise, forecast its end with remarkable accuracy.

But as many people pointed out, the problem with this kind of forecast is that it is difficult interpret the results. Does it really back Sornette’s hypothesis that crashes are predictable? How do we know that he doesn’t make these predictions on a regular basis and only publicise the ones that come true? Or perhaps he modifies them as the due date gets closer so that they always seem to be right (as weather forecasters do). It’s even possible that his predictions influence the markets: perhaps they trigger crashes.

Sornette himself is only too well aware of these problems and so has designed an experiment to properly test two hypotheses. The first hypothesis is that financial (and other) bubbles can be diagnosed in real-time before they end. And the second is that the termination of financial (and other) bubbles can be bracketed using probabilistic forecasts, with a reliability better than chance.

The experiment–he calls it the Financial Bubble Experiment–consists of Sornette and his team monitoring world markets and coming up with predictions about the forthcoming end of bubbles in the way they have been doing in recent years. But instead of publishing these predictions, Sornette intends to seal them in an electronic envelope held by a trusted third party, in this case, the physics arXiv.

The arXiv time stamps each prediction so that there is no dispute over when it was made and ensures that it cannot be changed.

Every six months, Sornette says he will open the envelopes and publish his predictions so that anyone can see how successful he has been.

That’s a brave step forward but one that he has little choice over, if his ideas are to be broadly accepted.

To start off with, he has made three forecasts which he’s posted to the arXiv. On 1 May 2010, he will unseal them and we’ll be waiting.

Exciting stuff.

Ref: arxiv.org/abs/0911.0454: The Financial Bubble Experiment: Advanced Diagnostics and Forecasts of Bubble Terminations