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