There are good reasons to think that stock markets are fundamentally unpredictable. Many econophysicists believe for example, that the data from these markets bear a startling resemblance to other data from seemingly unconnected phenomena, such as the size of earthquakes, forest fires and avalanches, which defy all efforts of prediction.
Some go as far as to say that these phenomena are governed by the same fundamental laws so that if one is unpredictable, then they all are.
And yet financial markets may be different. Last year, this blog covered an extraordinary forecasts made by Didier Sornette at the Swiss Federal Institute of Technology in Zurich, who declared that the Shanghia Composite Index was a bubble market and that it would collapse within a certain specific period of time.
Much to this blog’s surprise, his prediction turned out to be uncannily correct.
Sornette says there are two parts to his forecasting method. First, he says bubbles are markets experiencing greater-then-exponential growth. That makes them straightforward to spot, something that surprisingly hasn’t been possible before.
Second, he says these bubble markets display the tell signs of the human behaviour that drives them. In particular, people tend to follow each other and this result in a kind of herding behaviour that causes prices to fluctuate in a periodic fashion.
However, the frequency of these fluctuations increases rapidly as the bubble comes closer to bursting. It’s this signal that Sornette uses in predicting a change from superexponential growth to some other regime (which may not necessarily be a collapse).
While Sornette’s success last year was remarkable it wasn’t entirely convincing as this blog pointed out at the time
“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 believes he can spot.”
That’s when Sornette announced an brave way of test his forecasting method which he calls the Financial Bubble Experiment. His idea is to make a forecast but keep it secret. He posts it in encrypted form to the arXiv which time stamps it and ensures that no changes can be made.
Then, six months later, he reveals the forecast and analyses how successful it has been. Today, we can finally see the analysis of his first set of predictions made six months ago.
Back then, Sornette and his team identified four markets that seemed to be experiencing superexponential growth and the tell tale signs of an imminent bubble burst.
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