Financial Bubbles, Finite-Time Singularity Models

Financial Crisis Observatory

"The budget should be balanced,
the Treasury should be refilled,
public debt should be reduced,
the arrogance of officialdom
should be tempered and
controlled, and the assistance to
foreign lands should be curtailed
lest Rome become bankrupt.
People must again learn to work
instead of living on public
assistance."
Cicero - 55 BCE
D. Sornette
Professor of Entrepreneurial Risks at ETH Zurich
Professor of Finance at the Swiss Finance
Institute
Director of the Financial Crisis Observatory
co-founder of the Competence Center for Coping
with Crises in Socio-Economic Systems, ETH
Zurich (http://www.ccss.ethz.ch/)
Professor of Geophysics associated with the
Department of Earth Sciences (D-ERWD), ETH
Zurich
Professor of Physics associated with the
Department of Physics (D-PHYS), ETH Zurich
The ITC new economy bubble (1995-2000)
Slaving of the Fed monetary policy to the stock market descent
(2000-2003)
Real-estate bubbles (2003-2006)
MBS, CDOs bubble (2004-2007) and stock market bubble
(2004-2007)
Commodities and Oil bubbles (2006-2008)
Origin of the 2007-XXXX crisis:
15y History of bubbles and Dragon-kings
Didier Sornette and Ryan Woodard
Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis (2009)
(http://arxiv.org/abs/0905.0220)
Black Swan story

Unknown unknowable
event
!
cannot be diagnosed in advance,
cannot be quantied, no
predictability

No responsability (wrath
of God)

One unique strategy: long

put options and insurance
4
Black Swan (Cygnus atratus)
Crises are not black swans
but Dragon-kings

Most crises are

endogenous
!
can be diagnosed in advance,
can be quantied, (some) predictability

Moral hazard, conict of

interest, role of regulations

Responsibility, accountability

Strategic vs tactical time-

dependent strategy

Weak versus global signals

Dragon-king hypothesis
Michael Mandel http://www.businessweek.com/the_thread/economicsunbound/archives/2009/03/a_bad_decade_fo.html
POSITIVE FEEDBACKS
Beyond power laws: Dragon-kings
Material science: failure and rupture processes.
Geophysics: Characteristic earthquakes? Great avalanches?
Floods? Mountain collapses? Meteological events? and so on
Hydrodynamics: Extreme dragon events in the pdf of turbulent
velocity uctuations.
Financial economics: Outliers and dragons in the distribution of
nancial drawdowns.
Population geography: Paris as the dragon-king in the Zipf
distribution of French city sizes.
Brain medicine: Epileptic seizures
Metastable states in random media: Self-organized critical
random directed polymers
1. Geosciences of the solid envelop
1.1. Earthquake magnitude.
1.2. Volcanic eruptions.
1.3. Landslides.
1.4. Floods.
2. Meteorological and Climate sciences
2.1. Rains, hurricanes, storms.
2.2. Snow avalanches.
3. Material Sciences and Mechanical Engineering
3.1. Acoustic emissions.
3.2. Hydrodynamic turbulence.
4. Economics : nancial drawdowns, distribution of wealth
5. Social sciences: distribution of rm sizes, of city sizes, of social groups...
6. Social sciences : wars, strikes, revolutions, city sizes
7. Medicine: epileptic seizures, epidemics
8. Environmental sciences : extinctions of species, forest res
8.1. Evolution and extinction of species.
8.2. Forest res.
Special Issue EPJ ST SPRINGER
G. Ouillon and D. Sornette
Guest Editors (2011)
Academic Literature: No consensus on what is a bubble...
Ex: Refet S. Grkaynak, Econometric Tests of Asset Price Bubbles: Taking Stock.
Can asset price bubbles be detected? This survey of econometric tests of asset price bubbles
shows that, despite recent advances, econometric detection of asset price bubbles cannot be
achieved with a satisfactory degree of certainty. For each paper that nds evidence of bubbles,
there is another one that ts the data equally well without allowing for a bubble. We are still
unable to distinguish bubbles from time-varying or regime-switching fundamentals, while many
small sample econometrics problems of bubble tests remain unresolved.
What is a bubble?
Professional Literature: we do not know... only after the crash
The Fed: A. Greenspan (Aug., 30, 2002):
We, at the Federal Reserverecognized that, despite our suspicions, it was very
difficult to definitively identify a bubble until after the fact, that is, when its
bursting confirmed its existence Moreover, it was far from obvious that bubbles,
even if identified early, could be preempted short of the Central Bank inducing a
substantial contraction in economic activity, the very outcome we would be seeking
to avoid.
Positive feedbacks
Our proposition:
Faster than exponential
transient unsustainable
growth of price
What is a bubble?
H. Foerster et al., Science (1960)
10
Finite-time
Singularity
Planet formation in solar system by run-away accretion of planetesimals
11
Mechanisms for positive feedbacks in the stock market
Technical and rational mechanisms
1. Option hedging
2. Insurance portfolio strategies
3. Market makers bid-ask spread in response to past volatility
4. Learning of business networks, human capital
5. Procyclical financing of firms by banks (boom vs contracting times)
6. Trend following investment strategies
7. Asymmetric information on hedging strategies
Behavioral mechanisms:
1. Breakdown of psychological Galilean invariance
2. Imitation(many persons)
a) It is rational to imitate
b) It is the highest cognitive task to imitate
c) We mostly learn by imitation
d) The concept of CONVENTION (Orlan)
3. Social Proof mechanism
12
Imitation
-Imitation is considered an efficient mechanism
of social learning.
- Experiments in developmental psychology suggest that infants use imitation to get to
know persons, possibly applying a like-me test (persons which I can imitate and
which imitate me).
- Imitation is among the most complex forms of learning. It is found in highly socially
living species which show, from a human observer point of view, intelligent behavior
and signs for the evolution of traditions and culture (humans and chimpanzees, whales
and dolphins, parrots).
- In non-natural agents as robots, tool for easing the programming of complex tasks or
endowing groups of robots with the ability to share skills without the intervention of a
programmer. Imitation plays an important role in the more general context of
interaction and collaboration between software agents and human users.
Shiller (2000)
Humans Appear Hardwired To Learn By 'Over-Imitation'
ScienceDaily (Dec. 6, 2007) Children learn by imitating adults--so much so that they
will rethink how an object works if they observe an adult taking unnecessary steps when
using that object, according to a new Yale study.
14
Dynamics of noise traders
-Crash = coordinated sell-off of a large number of investors
-single cluster of connected investors to set the market off-balance
-Crash if 1) large cluster s>s* and 2) active
-Proba(crash) = n(s)
-Proba(active cluster) ~ s
a
with 1 < a < 2 (coupling
between decisions)
Proba(crash) ~ !
s>s*
n(s) s
a

If a=2, !
s>s*
n(s) s
2
~ |K-Kc
|"#
Equation showing optimal imitation solution of decision in absence of intrinsic information and in the presence
of information coming from actions of connected neighbors
This equation gives rise to critical transition=bubbles and crashes
+
D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch
Disorder : K small
Order
K large
Critical:
K=critical
value
Renormalization group:
Organization of the
description scale by scale
15
+
95
97 99 101
Financial bubble = maturation towards an instability
Instead of
Water Level:
-economic index
(Dow-Jones etc)
Crash = result of collective behavior of individual traders
(S. Solomon)
Page
The Power of
-Phase transitions
-Bifurcations
-Catastrophes
-Tipping points
Generically, close to a regime transition, a system
bifurcates through the variation of a SINGLE (or a few)
effective control parameter
(after J. Crutcheld)
Strategy 1: understand from proximity
to a reference point as a function of a
small parameter
Strategy 2: a few universal normal
forms
18
Fundamental reduction theorem
! Mlchael 1 1hompson (uAM1, Cambrldge)
recursors of 18 blfurcauons
! Mlchael 1 1hompson (uAM1, Cambrldge)
Interaction
(coupling) strength
Heterogeneity - diversity
10
1
0.1
0.01
0.001
0.001 0.01
0.1 1
10
SYNCHRONIZATION
EXTREME RISKS
SELF-ORGANIZED CRITICALITY
Coexistence of SOC
and Synchronized behavior
INCOHERENT
By classifying a system in a
given regime, we can assert
its degree of predictability.
Generic Prediction Phase Diagram
Signs of Upcoming Transition
Slower recovery from perturbations
Increasing autocorrelation
Increasing variance
Flickering and stochastic resonance
Increased spatial coherence
Early warning signals as predicted from theory:
D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch
Our prediction system is now used in the
industrial phase as the standard testing
procedure.
J.-C. Anifrani, C. Le Floc'h, D. Sornette and B. Souillard
"Universal Log-periodic correction to renormalization group scaling for rupture stress
prediction from acoustic emissions", J.Phys.I France 5, n6, 631-638 (1995)
Increasing variance
Increased spatial coherence
D-MTEC Chair of Entrepreneurial Risks

Prof. Dr. Didier Sornette www.er.ethz.ch
PREDICTABILITY of CRITICAL PARTURITION
-Amplitude of uctuations
-Response to external forcing
Generic Critical
Precursors
to a Bifurcation
Braxton hicks contractions
D. Sornette, F. Ferre and E.Papiernik, Mathematical model of human gestation and
parturition : implications for early diagnostic of prematurity and post-maturity", Int. J.
Bifurcation and Chaos 4, N3, 693-699 (1994)
Methodology for diagnosing bubbles
! Finite-time singular (FTS) models with LPPL on price
with self-consistent mean-reverting residuals
! Close-formed solutions of stochastic FTS
! Mutual entropy estimation methods for non-
stationarity
! FTS-GARCH on return time series
! Renormalization Group and Generalized Weierstrass
functions
26
Hong-Kong
Red line is 13.8% per year: but
The market is never following the average
growth; it is either super-exponentially
accelerating or crashing
Patterns of price trajectory during 0.5-1 year before each peak: Log-periodic power law
The ITC new economy bubble (1995-2000)
Slaving of the Fed monetary policy to the stock market descent
(2000-2003)
Real-estate bubbles (2003-2006)
MBS, CDOs bubble (2004-2007) and stock market bubble
(2004-2007)
Commodities and Oil bubbles (2006-2008)
Origin of the 2007-XXXX crisis:
15y History of bubbles and Dragon-kings
Didier Sornette and Ryan Woodard
Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the Financial and Economic Crisis (2009)
(http://arxiv.org/abs/0905.0220)
28
2000
29
NASDAQ ICT
2000
Real-estate
UK
mid-2004
Real-estate
USA
mid-2006
Oil July 2008 S&P500 USA Oct. 2007
30
CORN GOLD
SOYBEAN
WHEAT
R.Woodard and D.Sornette (2008)
31
PCA first component on a data set containing, emerging markets equity indices, freight indices, soft
commodities, base and precious metals, energy, currencies...
(Peter Cauwels FORTIS BANK - Global Markets)
The Global BUBBLE
2008
2003 2004 2005
2006
2007
2009
32
Financial Crisis Observatory (Aug. 2008)
www.er.ethz.ch/fco
33
Didier Sornette, Maxim Fedorovsky, Stefan Riemann, Hilary Woodard, Ryan Woodard,
Wanfeng Yan, Wei-Xing Zhou
34

Hypothesis H1: nancial (and other) bubbles

can be diagnosed in real-time before they end.

Hypothesis H2: The termination of nancial

(and other) bubbles can be bracketed using
probabilistic forecasts, with a reliability better
than chance (which remains to be quantied).
The Financial Bubble Experiment (Nov. 2009)
advanced diagnostics and forecasts of bubble terminations
! Positive feedbacks of higher return anticipation
"Super exponential price
"Power law Finite-time singularity
! Negative feedback spirals of crash expectation
"Accelerating large-scale financial volatility
"Log-periodic discrete scale-invariant patterns
Methodology for diagnosing bubbles
36
37
Silver
The Scientist
Volume 20 | Issue 2 | Page 51
FINANCIAL SYSTEM

The illusionary quest of society-at-large,

pensions funds, mutual funds... to gain
more than 2% return in real terms (above
inflation)

The gambling society (stardom

culture, emphasis on luck) vs work and
risk management

FOOD AND HEALTHCARE

The illusionary syndrome for blue pills

and red pills...

Principle of least effort (Zipf, 1949)

Principle of immediate or short-term

gratification (large discount rate)
The root cause of the crisis is our
illusion on nancial solution to
growth (high returns above GDP
growth).
The root cause of the coming
healthcare crisis is our illusion in
simple top-down control technical
solutions as opposed to account for
systemic network of networks.
Fundamental Origin of the Crises
(H. Takayasu)
HUMAN INTRINSIC WEAKNESSES
The Scientist
Volume 20 | Issue 2 | Page 51
FOOD AND HEALTHCARE

The food industry exploits our

weakness (addictive and/or
compensatory nature of some
foods).

The pharmaceutical industry

exploits our illusions for simple
solutions to health problems.
Fundamental failure to grasp the SYSTEM nature of the problems:
Instead, one problem => one proximate solution: THIS IS WRONG!
FINANCIAL SYSTEM

Bankers are sellers of dreams.

Bankers exploit our illusions and

cognitive limitations... like
casinos and lotteries...

Hong-Kong
Textbook example of a series of super-exponential
acceleration followed by crashes
43
Loss of Fiduciary Principle
!no man can serve two masters"
(J. Bogle, former CEO Vanguard group, JPM 2009)
Legal relationship of condence or
trust between two parties
The issue of moral relativism
Moral hazard
Incentives
Loss of Hippocratic oath
!nil nocere"
Fundamental conict of interest to
keep us marginally ill
Maximizing share-holder value
Rational focus on short-term in the
presence of large risks and
uncertainties
CONFLICTS OF INTERESTS
FINANCIAL SYSTEM FOOD AND HEALTHCARE
United States Share of wages and of
private consumption in Gross Domestic
Product (GDP)
Source of data and graphics: http://
hussonet.free.fr/toxicap.xls
Rate of profit and rate of accumulation:
The United States + European Union +
Japan
* Rate of accumulation = rate of
growth rate of the net volume of
capital * Rate of profit = profit/
capital (base: 100 in 2000)
Sources and data of the graphs:
http://hussonet.free.fr/toxicap.xls
Thee gap widens between the share of
wages and the share of consumption
(gray zones), so as to compensate for
the difference between profit and
accumul ati on. FINANCE al l ows
increasing debt and virtual wealth
growh... which can only be transitory
(even if very long).
44
rate of profit
savings
consumption
wages
The illusionary PERPETUAL MONEY MACHINE
transfer of wealth from populations
(young debtors buying houses
to financial assets (older sellers)
(Spencer Dale, Chief economist
Bank of England
45
Over the past decade and a half, (B - F) has
been closely correlated with realized capital
gains on the sale of homes. B-F=change in
home equi t y debt out st andi ng l ess
unscheduled repayment on RMDO
Alan Greenspan and James Kennedy (Nov. 2005)
Mortgage Equity Withdrawal
impact on GDP
source: John Mauldin (April 09)
Wealth Extraction
Solutions for Financial and biological Health?
Regulation and system design (Glass-Steagall act (1933);
Sarbanes-Oxley act (2002); Dodd-Frank act (2010)...)
Credit creation by banks (R. Werner)
The problem of institutional and academic memory loss
The key question: is there evidence that the new financial innovations and
a much expanded bank system has brought any real gain for innovations,
economic development, employment?
As Krugman suggested, is boring banking sufficient?
Financial innovations, High Frequency Trading... are
justied by claimed of improved welfare provided by
more LIQUIDITY and smaller FRICTION
Do we need so much liquidity?
Welfare
Liquidity
I
Financial innovations, High Frequency Trading... are
justied by claimed of improved welfare provided by
more LIQUIDITY and smaller FRICTION
Do we need so much liquidity?
Welfare
Liquidity
I
II
Financial innovations, High Frequency Trading... are
justied by claimed of improved welfare provided by
more LIQUIDITY and smaller FRICTION
Do we need so much liquidity?
Welfare
Liquidity
I
II
III
Financial innovations, High Frequency Trading... are
justied by claimed of improved welfare provided by
more LIQUIDITY and smaller FRICTION
Do we need so much liquidity?
Solutions for Financial and biological Health?
Soclal caplLal lncludes reclprocal eecLs, falrness, alLrulsm and oLher-
regardlng behavlor rule Lhe world.
Self-susLalnlng lncenuve Lo fosLer soclal caplLal" of a culLure /
socleLy / communlues / group.
lleld sLudles and lab experlmenLs ln close comblnauon wlLh complex
sysLem Lheory (A8M) can conslderably conLrlbuLe Lo lmprove Lhe
undersLandlng of cooperauon ln order Lo promoLe and spread a susLalnable
behavlor.
Solutions have to go very deep to the roots to develop a
culture of ethics, morality and respecting the duciary principle.
Mlcronance (?unus): Losses and defaulLs of mlcro credlLs are almosL negllglble.
1he lmplemenLauon of [olnL llablllues, soclal collaLeral and peer pressure
mechanlsms ensures a susLalnable, eecuve and emclenL way for self-help wlLhouL
spendlng money. Lendlng mlcro credlLs ls less rlsky and more proLable Lhan
sLandard lnvesLmenLs.

e8ay uses a slmple verslon of cross-reporung schemes. 8uyers and sellers can
publlcly raLe each oLher Lo prevenL abuse. 1hls raung opporLunlLy lmplemenLs an
addluonal feedback mechanlsm LhaL Lakes Lhe advanLage of susLalnlng cooperauon
by punlshlng norm vlolaLors/defecLors.

ulmenslon lund Advlsors (lnvesLmenL rm ln SanLa Monlca, 1981): culuvaung a

culLure of 1rusL (full dlsclosure, penalLy box", full dlsclosure prevenung asymmeLrlc
lnformauon)

SwlLzerland...
52
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