JIM PUPLAVA: Dr. Sornette, in your book, Why Stock Markets Crash, you take a different view from many experts in that the underlying cause of a stock market crash can often be found in preceding events, months or years before the markets crash itself, through what you call, cooperative activity. I wonder if you would explain that please.
DR. DIDIER SORNETTE: Yes, the concept of cooperative behavior is the crux of the matter. I like to take the following example. Consider a ruler or pen in your office or on your desk. Put it vertical and then release it. Most of the time it will fall on one side or the other, except if you are very talented and are able to keep it in the vertical position. The point is to ask why is the pen falling to one side or the other? You can have two explanations. One refers to its initial position. You had an imperfect position or a burst of air passed over it and pushed it onto one side. The more profound explanation is that the pen was prepared into an unstable position.
Similarly for the stock market, you have two classes or two levels of explanations. When you witness a crash, most of the time people invoke some news--some recent news--like a new tax law or interest rate increase. Something like that that just occurred a day before or a week before. What we have found in our work is that such local explanation does not actually describe the origin of the destabilization of the market. The fundamental explanation is probably going to be found similarly to the pen example, in that the market is building up into an instable position over months to years before the occurrence of the crash. We see this in the build up of specific patterns in the trajectories of such variables as the price, volume and volatility as a function of time. Typically we find evidence of an incoming instability in the precursory patterns of time trajectories of the price, volume and volatility variables. The time evolution of these variables tell us that these patterns are not sustainable and that an instability is ripening. This defines a bubble. For instance, the higher a bubble builds up, the more unstable becomes the market, until the point when any news or event could topple it.
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JIM: Finally, given your knowledge and study of the markets and why they crash, what is your view of where we are in the market currently. On your website you say that basically there is widespread evidence of cooperative herding and imitation working in this bear market that began in 2000.
DR. SORNETTE: Yes, we are not in a bubble, clearly. We are in what we call in my group an “anti-bubble”. We coined this term “anti-bubble” taking as an inspiration the concept of an “anti-particle” in physics. An anti-particle is the same as a particle but it annihilates when it encounters its sister particle. A positron is the anti-particle associated with the electron for instance. There are both the same and the opposite in a certain sense. I call the present trajectory of the US stock market an anti-bubble to refer to the fact that we see the same kind of patterns reflecting the positive feedback phenomena, but this does not lead to a bullish market but rather to a bearish market. Similarly to the characteristic power law acceleration and logperiodicity patterns characterizing bubbles, we find a power law deceleration and logperiodicity patterns characterizing the present trajectory of the US stock market. The patterns again reflect the competition between inertia and positive and negative feedbacks that I was referring to before. These are the technical elements that make me think that there is indeed a herding phenomena going on. In addition, there is the fact that I was also referring to before that the 13 most developed stock markets in the world have been essentially coinciding in their structure over the last two or three years.
I have published with my collaborator W.-X. Xhou at UCLA on December 2, 2002 , a paper published in Quantitative Finance, a scholarly journal. The paper was titled, The descent of the US Stock Market, how much longer and deeper. In this paper, we have issued a formal prediction of the future trajectory of the US stock market based on the ingredients I have described above. The prediction was made in August 2002, based on the data up to the end of August 2002 and we predicted that the stock market will go up until the first to the second quarter of 2003 and will then start a long descend until around the end of the first semester of 2004. That is what I can say at the present time. Each month, we are updating this prediction which is available on my website.
I would like to stress that making such a prediction is a rare thing to do for an academic. We did it because I wanted to do a real-time experiment. It's quite hard to make an experiment in social sciences. Of course one way to show you are right is to make money with that one thing. But my passion is research and I have not much time to give to create a company for implementing this. Even if I have colleagues I am working with who do it on hedge funds, I prefer to build up more and more of the research. It is a very exciting subject as are the real-time predictions that are developed as a way to prove or disprove what we are developing. This is one of the several experiments we are running.
Here is a quote from indisputably one of the greatest traders of all time, Jesse Livermore, who traded during the early 20th century and made over $100 million in one day during the 1929 crash:
"Nothing ever changes in the market—the only thing that changes are the players, and the new players have no financial memory of the previous major cycles, like the crash of 1907, or the crash of 1929, because they have not experienced them. It may be new to the speculator—but it's not new to the market." - Jesse Livermore
"The point at which a competitor is pursuing the best possible strategy, given the strategies of the other participants" - John F. Nash
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