Why Stock Markets Crash

Why Stock Markets Crash: Critical Events in Complex Financial Systems

Didier Sornette
Copyright Date: 2003
Pages: 448
https://www.jstor.org/stable/j.ctt7rzwx
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    Why Stock Markets Crash
    Book Description:

    The scientific study of complex systems has transformed a wide range of disciplines in recent years, enabling researchers in both the natural and social sciences to model and predict phenomena as diverse as earthquakes, global warming, demographic patterns, financial crises, and the failure of materials. In this book, Didier Sornette boldly applies his varied experience in these areas to propose a simple, powerful, and general theory of how, why, and when stock markets crash.

    Most attempts to explain market failures seek to pinpoint triggering mechanisms that occur hours, days, or weeks before the collapse. Sornette proposes a radically different view: the underlying cause can be sought months and even years before the abrupt, catastrophic event in the build-up of cooperative speculation, which often translates into an accelerating rise of the market price, otherwise known as a "bubble." Anchoring his sophisticated, step-by-step analysis in leading-edge physical and statistical modeling techniques, he unearths remarkable insights and some predictions--among them, that the "end of the growth era" will occur around 2050.

    Sornette probes major historical precedents, from the decades-long "tulip mania" in the Netherlands that wilted suddenly in 1637 to the South Sea Bubble that ended with the first huge market crash in England in 1720, to the Great Crash of October 1929 and Black Monday in 1987, to cite just a few. He concludes that most explanations other than cooperative self-organization fail to account for the subtle bubbles by which the markets lay the groundwork for catastrophe.

    Any investor or investment professional who seeks a genuine understanding of looming financial disasters should read this book. Physicists, geologists, biologists, economists, and others will welcomeWhy Stock Markets Crashas a highly original "scientific tale," as Sornette aptly puts it, of the exciting and sometimes fearsome--but no longer quite so unfathomable--world of stock markets.

    eISBN: 978-1-4008-2955-2
    Subjects: Economics, Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-xii)
  3. Preface
    (pp. xiii-2)
    Didier Sornette
  4. CHAPTER 1 FINANCIAL CRASHES: WHAT, HOW, WHY, AND WHEN?
    (pp. 3-25)

    Stock market crashes are momentous financial events that are fascinating to academics and practitioners alike. According to the academic world view that markets are efficient, only the revelation of a dramatic piece of information can cause a crash, yet in reality even the most thorough post-mortem analyses are typically inconclusive as to what this piece of information might have been. For traders and investors, the fear of a crash is a perpetual source of stress, and the onset of the event itself always ruins the lives of some of them.

    Most approaches to explaining crashes search for possible mechanisms or...

  5. CHAPTER 2 FUNDAMENTALS OF FINANCIAL MARKETS
    (pp. 26-48)

    Notwithstanding the drama surrounding crashes, there is a growing body of scholarly work suggesting that they are part of the family of usual daily price variations; this view, which is rooted theoretically in some branches of the theory of complex systems, posits that there is no characteristic scale in stock market price fluctuations [287]. As a consequence, the very large price drops (crashes) are nothing but small drops that did not stop [26]. According to this view, since crashes belong to the same family as the rest of the returns we observe on normal days, they should be inherently unpredictable...

  6. CHAPTER 3 FINANCIAL CRASHES ARE “OUTLIERS”
    (pp. 49-80)

    In the spirit of Bacon inNovum Organumabout 400 years ago, “Errors of Nature, Sports and Monsters correct the understanding in regard to ordinary things, and reveal general forms. For whoever knows the ways of Nature will more easily notice her deviations; and, on the other hand, whoever knows her deviations will more accurately describe her ways,” we propose in this chapter that large market drops are “outliers” and that they reveal fundamental properties of the stock market.

    Stock markets can exhibit very large motions, such as rallies and crashes, as shown in Figures 2.4 and 2.5. Should we...

  7. CHAPTER 4 POSITIVE FEEDBACKS
    (pp. 81-133)

    The previous chapter 3 documented convincingly that essentially all markets exhibit rare but anomalously large runs of successive daily losses. How can we explain the existence of these exceptionally large drawdown outliers?

    Since it is the actions of investors whose buy and sell decisions move prices up and down, any deviation from a random walk has ultimately to be traced back to the behavior of investors. We are particularly interested in mechanisms that may lead to positive feedbacks on prices, that is, to the fact that, conditioned on the observation that the market has recently moved up (respectively, down), this...

  8. CHAPTER 5 MODELING FINANCIAL BUBBLES AND MARKET CRASHES
    (pp. 134-170)

    Knowledge is encoded in models. Models are synthetic sets of rules, pictures, and algorithms providing us with useful representations of the world of our perceptions and of their patterns. As argued by philosophers and shown by scientists, we do not have access to “reality,” only to some of its manifestations, whose regularities are used to determine rules, which when widely applicable become “laws of nature.” These laws are constantly tested in the scientific march, and they evolve, develop and transmute as the frontier of knowledge recedes further away.

    Like a novel, a model may be convincing—it may ring true...

  9. CHAPTER 6 HIERARCHIES, COMPLEX FRACTAL DIMENSIONS, AND LOG-PERIODICITY
    (pp. 171-227)

    The previous chapter 5 put forward the concept that a critical point in the time domain, or equivalently a finite-time singularity, underlies stock market crashes. A crash is not the critical or singular point itself, but its triggering rate is strongly influenced by the proximity of the critical point: the closer to the critical time, the more probable is the crash. We have seen that the hallmark of critical behavior is a power law acceleration of the price, of its volatility, or of the crash hazard rate, as the critical timetcis approached. The purpose of the present chapter...

  10. CHAPTER 7 AUTOPSY OF MAJOR CRASHES: UNIVERSAL EXPONENTS AND LOG-PERIODICITY
    (pp. 228-280)

    As discussed in chapter 1, the crash of October 1987 and its Black Monday on October 19 remains one of the most striking drops ever seen in stock markets, both by its overwhelming amplitude and its encompassing sweep over most markets worldwide. It was preceded by a remarkably strong “bull” regime epitomized by the following quote fromThe Wall Street Journalon August 26, 1987, the day after the 1987 market peak: “In a market like this, every story is a positive one. Any news is good news. It’s pretty much taken for granted now that the market is going...

  11. CHAPTER 8 BUBBLES, CRISES, AND CRASHES IN EMERGENT MARKETS
    (pp. 281-319)

    In periods of optimistic consensus, emerging markets have the favor of investors looking for opportunities to leverage their returns. Bubbles may ensue, and their demise is often associated with large swings and extreme corrections leading to financial crises [271].

    Holdings of foreign stock by U.S. residents reached 10% of all equity holdings, or $876 billion by the end of 1996. More than one-third of that, $336 billion, was held through U.S. mutual funds specializing in international (non-U.S.) and global markets. Global and international mutual funds now represent 12.1% of net assets in long-term equity and bond funds. In addition, public...

  12. CHAPTER 9 PREDICTION OF BUBBLES, CRASHES, AND ANTIBUBBLES
    (pp. 320-354)

    The time arrow is inexorably projecting us towards the undetermined future. Predicting the future captures the imagination of all and is perhaps the greatest challenge. “Prophets” have historically terrified or inspired the masses by their visions of the future. Until recently, science has mostly avoided this question by focusing on another kind of prediction, that of novel phenomena such as the prediction by Einstein of the deviation of light by the sun’s gravitation field, the prediction of the elusive particles called neutrinos by Pauli, and the prediction of the intermediate bosons within the electroweak theory by Weinberg and Salam, to...

  13. CHAPTER 10 2050: THE END OF THE GROWTH ERA?
    (pp. 355-396)

    How will the stock markets of the world behave in the months, years, or even decades ahead of us? This question underlies much of our economic future and well-being. As discussed in previous chapters, countries around the world are relying increasingly on the stock market for the retirement of their elders, for quantifying the value of companies, and for characterizing the health of the economy in general. In addition, the stock market has become a powerful engine of both developed and emerging economies as the principal source of liquidity and capital for investment.

    At the end of the twentieth century,...

  14. References
    (pp. 397-418)
  15. Index
    (pp. 419-421)