Why Stock Markets Crash
Log-periodic power laws as a physicist's model of crash formation
Summary
Sornette, a geophysicist who applies statistical physics to financial markets, argues that large market crashes are not caused by the news that appears to trigger them but are endogenous outcomes of a cooperative process among traders, and that they are preceded by an identifiable signature.
His model treats a bubble as a system in which traders imitate one another with increasing strength, producing positive feedback. As imitation increases the system approaches a critical point, and the price path in that regime follows a specific mathematical form: faster-than-exponential growth decorated with accelerating oscillations, which he calls log-periodic power law behaviour. The oscillations arise from a discrete scale invariance in the underlying interaction structure. He argues this signature is detectable in advance and fits it to the 1929, 1987 and 2000 episodes and to several others including the 1997 Asian crisis.
The conceptual claim, that a crash is the culmination of a slow build-up of internal instability rather than a response to an external shock, is well supported by the observation that no adequate news event has ever been identified for the largest crashes.
The predictive claim is where the dispute lies. Critics have argued the log-periodic fits have too many free parameters, that the pattern can be fitted to price series with no subsequent crash, and that out-of-sample performance has been poor and selectively reported. Sornette has made public predictions with mixed results. The book requires mathematics and is written for readers comfortable with statistical physics.
Key takeaways 7
- Large market crashes are endogenous outcomes of a build-up of internal instability rather than responses to the news events that appear to trigger them.
- No adequate external cause has ever been identified for the largest crashes, which is the empirical basis for treating them as internally generated.
- Bubbles arise from traders imitating one another with increasing strength, which produces positive feedback and drives the system toward a critical point.
- Prices in a bubble regime grow faster than exponentially, which is unsustainable by construction and identifies the state independently of any valuation judgement.
- Accelerating oscillations superimposed on the price path constitute a signature that Sornette claims is detectable before the crash.
- A crash occurs when the system reaches criticality, at which point any small disturbance can trigger it, which is why the trigger appears arbitrary.
- The date of a crash is not determined by the model, only the regime, which limits what the method can be used for in practice.
Who should read it
Quantitatively inclined investors interested in the physics-based account of endogenous crashes, with the predictive claims treated as disputed.
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