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Why Stock Markets Crash, by Didier Sornette (Amazon)
Sornette's monthly update (UCLA faculty site)
Chart of the S&P 500 over a chart of the Nikkei
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The physics of financial catastrophe
Every bubble has the same story, says Didier Sornette. He's made his life's work predicting catastrophe -- and his next call is that U.S. markets won't shake the bear until 2004.
By Jon D. Markman
Slight, soft-spoken Didier Sornette is a master of disaster, a scientist who has made the forecasting of catastrophe in space, on land, in cities and in the market his lifes work.
He started two decades ago in France with seminal work on the predictability of rocket-engine ruptures and failures, then earned a professorship in geophysics at UCLA by applying his complex-systems research to the more grounded task of predicting waves of tectonic ruptures that lead to earthquakes. Next week, he meets with the Dutch government to explain how his models predict the sort of societal ruptures that result in waves of urban criminality.
But all of those efforts are childs play next to the work he has undertaken on behalf of investors. In a new book, Why Stock Markets Crash, the polymathic physicist proposes that complex-system theory can explain and predict both the emergence of financial bubbles as well as their rupture and path of recovery.
So far, so good. The book was just published this month, but Sornette has been issuing papers in academic journals that have quietly made accurate financial predictions ranging from the 1999 resurgence of the Japanese stock market and its follow-on decline, as well as much of the U.S. market action last year. His latest predictions, made without reliance on any of the usual technical, seasonal or economic indicators in vogue on Wall Street, suggested in August that U.S. stocks would sink into October but then rally sharply into the start of 2003.
Sornettes fractal model suggests that the current rally will stall shortly and that prices will subsequently retreat much lower over the next 12 months to 18 months, punctuated from time to time by strong countertrend rallies. After the S&P 500 Index ($INX) reaches the low- to mid-600s from its current perch around 925, his model predicts a multiyear period of convalescence for U.S. stocks before a new bull phase pushes prices back toward and beyond their 2000 highs. He promises to provide a monthly update on his prediction at his UCLA faculty Web site (use the link at left under "Related Sites").
Follow the leader
What is risky and novel about his work is that it suggests that investors conform to herding behavior much like the particles in a magnet and that long periods of imitative cooperation ultimately lead first to bubbles, then to short periods of extreme instability, rupture and catastrophic failure. Even though individuals appear to act of their free will when viewed under a microscope, when viewed macroscopically as a system he believes they act in non-random patterns that -- much like molecules in a pressurized container of gas -- can be captured with the precision of a mathematical formula.
A less brave scientist would be content to let the ideas provide grist for financial practitioners, but Sornette has taken the unusual step of issuing forecasts because it is the only way to prove to skeptics that his work has the necessary scientific rigor to be reproducible. I am risking my reputation because I am convinced that there is an important truth in the theory that I have described, and the best way to convince my colleagues is to issue forward predictions, Sornette said.
Theres a paradox here, of course. He points out that if his theory merely does a good job of describing the past it will be considered to be just a figment of pattern recognition -- interesting, maybe, but not revolutionary. And yet, if he does such a great job that investors change their behavior and avoid a forecast result, then his prediction will be considered incorrect. He notes in the book that he faces three unattractive scenarios:- Nobody believes the prediction for a coming decline. It is correct, and the market crashes. This would be a victory for the predictor, but skeptics would probably put it down as a lucky shot without statistical significance.
- Everyone believes the warning. It causes panic, and the market crashes as a consequence. The prediction thus seems self-fulfilling, and success is attributed more to the panic effect than to real predictive power.
- So many investors believe that the predictions might be correct that they make reasonable adjustments. Then, the steam goes out of the bubble. The prediction thus disproves itself.
Sornette acknowledges that this Catch 22 is the inescapable lot of scientific investigations into systems made up of humans with learning and reflective abilities -- and stands in contrast to the usual inanimate and unchanging physical laws of nature. If he just published his findings in obscure physics journals, later on he could emerge with a press release and say he told us so. But as a new breed of scientist who is engaged with the public, he believes that an increased awareness of the potential for market instabilities will help construct a more stable, efficient stock market.
Every bubble's story
Sornette studied and characterized 50 bubbles in various financial markets around the world -- gold, currencies, stocks and more -- en route to developing his theory with a team of researchers. The story of the stock bubbles, he said, is always the same: In the first stage, the economy is good, corporate earnings are peaking and analysts are bullish that good times will continue upward in a straight line. In a second stage, companies managed by people who are interacting with a positive media and their fellow leaders feel good about borrowing money from banks -- and their expansion attracts more investment. This additional influx of funds fuels the engine and throttles the collective market up more, creating a positive feedback loop that advances until even your grandmother cannot resist the attraction and will take money from under the mattress to put into stocks.
As prices begin to reach a parabolic stage of accelerated increase, which can be characterized in every case with a signature slope, the market reaches an unstable stage at which any perturbation -- an interest-rate increase, geopolitical change or something relatively prosaic -- can cause it to go critical, or crash. Sornettes work is aimed at understanding the time frame for that window of instability. Think of a ruler standing on your finger, he explains. Its very unstable. You need to keep moving the finger to stabilize it. What will cause it to fall? It could be the slightest movement of your finger, or the wind. Those things would just be the proximate cause, however. It actually fell because it was in an unstable situation.
In his book, which is readable despite being replete with mathematical equations, Sornette shows how the interactions between market players -- investors, bankers, analysts, corporate managers, government officials -- are like the interactions between molecules in a rocket engine. None are truly isolated from each other as they exchange information and emerge as a global macroeconomic entity. After a crash, Sornette shows mathematically that the same herding effects that blow up a bubble then lead to a quantifiable network of remorse that creates a signature anti-bubble of negative feedback and declining prices. The archetype for an anti-bubble is the Japanese stock market since 1989. And Sornette says that it is virtually inescapable that the U.S. market will follow the same path of long-term decline. (Use the links at left under "Related Sites" for a chart of the S&P 500 overlaid with time delay over the a chart of the Nikkei.)
The herd mentality sets Sornette's work apart
It is this holistic view of a world full of investors acting together that distinguishes Sornettes work from both traditional economic theory as well as the new wave of behavioralism. The old school approach, called utility theory, holds that each investor is able to optimize his attempt to accumulate wealth by making rational, accurate judgments about the future. That view was essentially replaced by prospect theory, which holds that people are more sensitive to changes in their level of wealth than they are to their absolute level of wealth. The latest view, crowned with the 2002 Nobel Prize for Economics to Princetons Daniel Kahneman and Vernon Smith of George Mason University, holds that people are not terribly rational about the relationship with the future. Instead, they make mistakes by overestimating their ability to beat the market by taking risks.
Sornettes work suggests that all of these approaches are similar to one-body theories of physics in that they deal only with the preferences and choices of a single person. Its as if a physicist tried to understand a gas by scrutinizing the actions of a single molecule. In contrast, he thinks it is more valuable to understand how individuals misapprehensions about the future aggregate into the emergence of global behavior that ultimately can be categorized and analyzed mathematically.
The bottom line is that Sornettes work does not anticipate another crash in the U.S. stock market; that has already occurred. Instead he simply anticipates the continuation of a bearish phase of cooperative herding as individuals collectively continue to wish unproductively for an end to the decline. It will come, he says, but just not until the middle of 2004.
Ill stay in touch with Sornette over the next 18 months and keep you updated on his predictions. Let me know what you think of his approach by mailing me at jonmark@runbox.com; if youve got a scientific bent let me urge you to read his book before asking me any hard questions. Its available at Amazon.com for $21 (you can use the link at left under "Related Sites").
Fine Print
When hes not a geophysics professor at UCLA, forecasting stock prices, predicting earthquakes, advising governments on crime or studying economic history, Sornette is research director at the Centre National de la Recherche Scientifique. He lives in Nice with his wife and two children. I think his next research project should be a study of how he manages to find the time for all this. When I asked him how he balances family life with efforts to save the world, he sighed and said the ideal scientist would be a monk. By the way, if youve ever wanted to visit Tokyo, youd better hurry up. He says its overdue for a city-leveling earthquake along the lines of the one that hit in 1923. That 8.3 temblor killed 100,000 people and left 40,000 missing. If it hits, Sornette estimates potential damage at over $1 trillion. Complex systems research into critical events is one of the hottest fields in science. You may have heard that the Gulf Stream is cooling as a consequence of global warming. The reasoning goes like this: Earth warms up to a critical point at which precipitation declines, density of ocean water in the North Atlantic dilutes, the Gulf Stream submerges, and Europe cools 3-5 degrees. That would bring on a new Ice Age in a catastrophic transition of as little as 25 years to 40 years. Sornette estimates the cost of that at around $3 trillion. In Chapter 10 of his book, you can read why he thinks the growth era of Western civilization will end in the year 2050. Closer to home, readers continue to offer suggestions on ways to play the potential w-fi theme. Several recommended Symbol Technologies (SBL, news, msgs), a company known primarily for its dominance of the bar-code reading world. The New York company also has a busy wireless division that is building wi-fi local area networks for retailers, hotels, college campuses, manufacturing plants and warehouses. (See this page). The stock is not cheap, but its reasonably priced for a proven growth company. Ill add it to our Wi-Fi Watchlist at the Jan. 13 price of $9.70. Its definitely one tech stock I would pick up during the next panic if it were to revisit the $5 area. Best stock so far in our watch list is PCTEL (PCTI, news, msgs), up 12% in the past week.
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