Dragon-kings and Predictions

Diagnostics and Forecasts for the World Financial Crisis

Didier SORNETTE

Chair of Entrepreneurial Risks

Department of Management, Technology and

Economics, ETH Zurich, Switzerland

Member of the Swiss Finance Institute

co-founder of the Risk Center at ETH Zurich

(June 2011) (www.riskcenter.ethz.ch)

associated with the Department of Physics (D-

PHYS), ETH Zurich

associated with the Department of Earth

Sciences (D-ERWD), ETH Zurich

www.er.ethz.ch
 Extreme events are epoch changing
in the physical structure and in the mental spaces

• Droughts and the collapse of the Mayas (760-930 CE)... and

many others... (J. Diamond, Collapse, 2005)
• French revolution (1789) and the formation of Nation states +
intensity of wars (C. Warren, L.-E. Cederman and D. Sornette, Testing Clausewitz:
Nationalism, Mass Mobilization, and the Severity of War, International Organization, 2011)

• Great depression and Glass-Steagall act

• Crash of 19 Oct. 1987 and volatility smile (crash risk) (D.
MacKenzie, An Engine, Not a Camera, 2006)

• Enron and Worldcom accounting scandals and Sarbanes-

Oxley act (2002)
• Great Recession 2007-2009: Dodd-Frank act
• European sovereign debt crisis: Europe or collapse?
5
Standard view: fat tails, heavy tails and
Power law distributions
const
10 −1
ccdf (S) = µ
complementary cumulative S
10 −2 distribution function
10 −3
10 −4
10 −5
10 −6
10 −7
10 2
10 3
10 4
10 5 10 6 10 7
Most extremes are dragon-kings
 Paris as a dragon-king

2009

8 ``Fat tails''
Jean Laherrere and Didier Sornette, Stretched exponential distributions in Nature and Economy:
with characteristic scales, European Physical Journal B 2, 525-539 (1998)
Dragon-kings results from maturation towards an instability
Instead of
Water Level:
-economic index
(Dow-Jones etc…)

95 C 97 C 99 C 101 C

Crash = result of collective behavior of individual traders

(Sorin Solomon)
 Fundamental reduction theorem
Generically, close to a regime transition, a system
bifurcates through the variation of a SINGLE (or a few)
effective “control” parameter

Strategy 1: understand from

proximity to a reference point as
a function of a small parameter

Strategy 2: a few universal

“normal forms”

10
 Signs of Upcoming Transition
Early warning signals as predicted from theory

• Slower recovery from perturbations

• Increasing (or decreasing) autocorrelation

• Increasing (or decreasing) cross-correlation with external driving

• Increasing variance

• Flickering and stochastic resonance

• Increased spatial coherence

• Degree of endogeneity/reflexivity

• Finite-time singularities
 Diagnostic of Ariane rocket pressure tanks

• Increasing variance
• Increased spatial coherence
• Finite-time singularity
Our prediction system is now used in the industrial phase as the standard testing procedure.
Prof. Dr. Didier Sornette www.er.ethz.ch D-MTEC Chair of Entrepreneurial Risks
 PARTURITION and EPILEPTIC SEIZURES
Generic Critical
Precursors
to a Bifurcation

Braxton hicks contractions

-Amplitude of fluctuations
-Response to external forcing
Beyond power laws: 8 examples of “Dragons”
Financial economics: Outliers and dragons in the distribution of financial
drawdowns.
Population geography: Paris as the dragon-king in the Zipf distribution of
French city sizes.
Material science: failure and rupture processes.
Hydrodynamics: Extreme dragon events in the pdf of turbulent velocity
fluctuations.
Metastable states in random media: Self-organized critical random directed
polymers

Brain medicine: Epileptic seizures

Geophysics: Characteristic earthquakes? Great avalanches?
Floods? Mountain collapses? Meteological events? and so on

Ionosphere and magneto-hydrodynamics: Global auroral energy deposition

Extreme Risks: Dragon-Kings versus Black Swans

Special Issue EPJ ST

SPRINGER
D. Sornette and G. Ouillon
Guest Editors (May 2012)
bubble peaking in Oct. 2007

16
 THE GREAT RECESSION
(2008-2009)

30’000 billions US $
Stock markets losses

20’000
direct subprime loss

10’000 World GDP loss

 Positive feedbacks
-bubble phase
-crash phaset

positive feedback of increasing return

=> growth of the return (and not just of the price)

=> Faster-than-exponential transient unsustainable growth of price

=> Mathematically, this translates into FINITE-TIME SINGULARITY

Growth Processes

 exponential growth
p(t) ∼ et

 finite-time singularity
1
p(t) ∼
(tc − t)1/δ

 power-law
p(t) ∼ t1/|δ|
Super-exponential growth
(positive feedbacks)

Korotayev, Malkov
Khaltourina (2006)

GDP
Multivariate endogeneous growth models and FTS
Case θ+β>1 : FTS

technology

capital
 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. Algorithmic trading
8. Asymmetric information on hedging strategies
9. Stop-loss orders
10.Portfolio execution optimization and order splitting
11.Deregulation (Grimm act repelling the Glass-Steagal act)

• 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” (Orléan)
3. “Social Proof” mechanism
22
 Collective behavioral phenomena
Imitation
Imitation THE JOURNAL OF FINANCE • VOL. LX, NO. 6 • DECEMBER 2005

Thy Neighbor’s Portfolio: Word-of-Mouth Effects

in the Holdings and Trades of Money Managers

HARRISON HONG, JEFFREY D. KUBIK, and JEREMY C. STEIN∗

ABSTRACT
A mutual fund manager is more likely to buy (or sell) a particular stock in any quarter
if other managers in the same city are buying (or selling) that same stock. This pattern
shows up even when the fund manager and the stock in question are located far apart,
so it is distinct from anything having to do with local preference. The evidence can
be interpreted in terms of an epidemic model in which investors spread information
about stocks to one another by word of mouth.

IN THIS PAPER, WE EXPLORE THE HYPOTHESIS that investors spread information and
ideas about stocks to one another directly, through word-of-mouth communica-
tion. This hypothesis comes up frequently in informal accounts of the behav-

Informational cascades ior of the stock market.1 For example, in his bestseller Irrational Exuberance,
Shiller (2000) devotes an entire chapter to the subject of “Herd Behavior and
Epidemics,” and writes

A fundamental observation about human society is that people who

communicate regularly with one another think similarly. There is at any
place and in any time a Zeitgeist, a spirit of the times. . . . Word-of-mouth
transmission of ideas appears to be an important contributor to day-to-day
or hour-to-hour stock market f luctuations. (pp. 148, 155)

However, in spite of its familiarity, this hypothesis about word-of-mouth in-

formation transmission has received little direct support in stock market data.2
Humans Appear Hardwired To Learn By 'Over-Imitation'
∗
Hong is from Princeton University, Kubik is from Syracuse University, and Stein is from both
ScienceDaily (Dec. 6, 2007) — Children learn by imitating adults--so much so that
Harvard University and the National Bureau of Economic Research. Thanks to the National Sci-
they will rethink
ence how an
Foundation objectsupport,
for research worksandiftothey
Rebeccaobserve
Brunson andanRaviadult taking
Pillai for research unnecessary
assis-
tance. We are also grateful for comments and suggestions from Julian Abdey, Malcolm Baker, Gene
steps whenD’Avolio,
usingChipthat object,
Fortson, according
Rick Green, to aKarl
Rafael LaPorta, new Yale
Lins, study.
Burton Malkiel, Anna Scherbina,
Andrei Shleifer, Jeff Wurgler, and the referee, as well as from seminar participants at Harvard
Business School, Boston College, the University of Texas, New York University, Columbia, North-
western, Maryland, the University of Southern California, Penn State, Syracuse, and the Western
Finance Association meetings.
“Well, heck! If all you smart cookies agree, who am I to dissent?” 1

2
See, for example, Ellison and Fudenberg (1995) for a formal model of word-of-mouth learning.
However, recent work has done much to advance the more general proposition that local peer
group effects can have important consequences for a number of other economic outcomes, including
 Universal Bubble and Crash Scenario

Displacement

Credit creation

Euphoria

Critical stage / Financial distress

Revulsion
Charles Kindleberger, Manias, Panics and Crashes (1978)

Didier Sornette, Why stock markets crash (2003)

24
 Famous historical bubbles

Semper Augustus

Source: Elliott Wave International; data source for South Seas, Global Financial Data
 Positive feedbacks and origin of bubbles

Prices in the learning-to-forecast market experiments

Next period returns r(t+1)versus current returns r(t)
(Hommes et al., 2008).
for group 2. Points on the diagonal correspond to
Five out of six markets exhibit long lasting bubbles
constant growth rate (r(t+1)= r(t)), points above the
with asset prices increasing to more than 15 times
diagonal (r(t+1)> r(t)) correspond to accelerating
fundamental value.
growth. Returns are defined as discrete returns:
A. Hüsler, D. Sornette and C. H. Hommes Super-exponential bubbles in lab r(t+1) = [p(t+1)/p(t)] − 1.
experiments: evidence for anchoring over-optimistic expectations on price,
Journal Economic Behavior and Organization 92, 304-316 (2013)
Bitcoin, April 2013
 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

28
 Log-Periodic Power Law model and Extensions

From the perspective of economics From the perspective of complex

and econometrics: systems:

Rational expectation bubble model Rational expectation models

in the presence of of negative bubbles
an (unknown) fundamental value and anti-bubbles

Rational expectation bubble model Rational expectation bubble model

in the presence of with beta-function-type solution of
stochastic singularity time the RG
(RG: renormalization group)

Rational expectation bubble model

Rational expectation bubble model
in the presence of
with higher order solutions of the
mean-reverting self-consistent
RG
residuals
 The Log-Periodic Power Law is a combination of

Classical methods of economics: Complex systems approach:

extension of the Blanchard-Watson (1982)
Rational Expectation bubble model
The crash is a tipping point (critical
point), around which the system
Diffusive dynamics of log-price in the exhibits self-similar properties:
presence of discontinuous jump j:

The renormalisation group solution has

the form:
Under the no-arbitrage condition

the excess returns are proportional to Where the log-periodic oscillations for
the hazard rate: hazard rate are the first order
approximation of the RG solution.
 The Log-Periodic Power Law is a combination of

Classical methods of economics:

extension of the Blanchard-Watson (1982)
Rational Expectation bubble model

Diffusive dynamics of log-price in the

presence of discontinuous jump j:

Under the no-arbitrage condition

the excess returns are proportional to

the hazard rate:
The Log-Periodic Power Law is a combination of

Complex systems approach:

The crash is a tipping point (critical

point), around which the system
exhibits self-similar properties:

The renormalisation group solution has

the form:

Where the log-periodic oscillations for

hazard rate are the first order
approximation of the RG solution.
 The Log-Periodic Power Law is a combination of

Classical methods of economics: Complex systems approach:

extension of the Blanchard-Watson (1982)
Rational Expectation bubble model
The crash is a tipping point (critical
point), around which the system
Diffusive dynamics of log-price in the exhibits self-similar properties:
presence of discontinuous jump j:

The renormalisation group solution has

the form:
Under the no-arbitrage condition

the excess returns are proportional to Where the log-periodic oscillations for
the hazard rate: hazard rate are the first order
approximation of the RG solution.
 Positive feedback Discrete scale invariance
with d>1
e.g. as a result of herding in dynamics of as a result of RG solution around the
“noise traders” tipping point (end of bubble)

Faster-than exponential growth Log-periodic oscillations

Martingale hypothesis
(no “free lunch”)

Johansen-Ledoit-Sornette (JLS) model

(Log-Periodic Power Law)
Extensions of the Log-Periodic Power Law model

From the perspective of economics From the perspective of complex

and econometrics: systems:

Rational expectation bubble model Rational expectation models

in the presence of of negative bubbles
an (unknown) fundamental value and anti-bubbles

Rational expectation bubble model Rational expectation bubble model

in the presence of with beta-function-type solution of
stochastic singularity time the RG
(RG: renormalization group)

Rational expectation bubble model

Rational expectation bubble model
in the presence of
with higher order solutions of the
mean-reverting self-consistent
RG
residuals
 Extensions of the Log-Periodic Power Law model

From the perspective of economics From the perspective of complex

and econometrics: systems:

Rational
addresses expectation bubble
the problem model
of the joint Rational expectation models
in the
estimation presence
of the of
fundamental and of negative bubbles
an (unknown) fundamental value
bubble components and anti-bubbles

mechanism
Rational for bubble
expectation survival
bubble by
model Rational expectation bubble model
lack ofinsynchronization
the presence ofdue to with beta-function-type solution of
heterogenous
stochasticbeliefs on critical
singularity time end the RG
of bubble (RG: renormalization group)

Rational expectation bubble model

Rational expectation bubble model
in the presence of
with higher order solutions of the
mean-reverting self-consistent
RG
residuals
 Construction of alarms
Prices converted in stochastic singular times for crash

Bubble diagnostic if

(iv) Dickey − Fuller unit − root test is rejected at 99.5% significance level
(iii)
Li Lin, Didier Sornette, Diagnostics of Rational Expectation Financial Bubbles with Stochastic Mean-Reverting Termination Times, in press in European Journal of Finance
(2012) (http://arxiv.org/abs/0911.1921)
 Extensions of the Log-Periodic Power Law model

From the perspective of economics From the perspective of complex

and econometrics: systems:

Rational
addresses expectation bubble
the problem model
of the joint Rational expectation models
in the
estimation presence
of the of
fundamental and of negative bubbles
an (unknown) fundamental value
bubble components and anti-bubbles

mechanism
Rational for bubble
expectation survival
bubble by
model Rational expectation bubble model
lack ofinsynchronization
the presence ofdue to with beta-function-type solution of
heterogenous
stochasticbeliefs on critical
singularity time end the RG
of bubble (RG: renormalization group)

Rational expectation
addresses the criticbubble model
of Granger Rational expectation bubble model
in the presence
and Newbold (1974) and of Phillips
with higher order solutions of the
mean-reverting
(1986) self-consistent
about spurious fits of non- RG
residuals
stationary price processes
A Consistent Model of ʻExplosiveʼ Financial Bubbles
With Mean-Reversing Residuals
L. Lin, R. E. Ren and D. Sornette (2009)

http://papers.ssrn.com/abstract=1407574
 Rational Expectation formulation

There is also a Behavioral discount factor formulation.

 Bayesian approach
S&P500 1987 and Hong-Kong 1997
(answering to Chang and Feigenbaum, 2006)
Extensions of the Log-Periodic Power Law model

From the perspective of complex

systems:

Rational expectation models

of negative bubbles
and anti-bubbles

Rational expectation bubble model

with beta-function-type solution of
the RG
(RG: renormalization group)

Rational expectation bubble model

with higher order solutions of the
RG
Extensions of the Log-Periodic Power Law model

From the perspective of complex

systems:

Rational expectation models

of negative bubbles
and anti-bubbles
 Rational expectation models of negative and anti-bubbles

Price

Positive bubble Positive anti-bubble

(the pressure builds up, (the pressure is progressively
generally in multiple stages) released, generally in multiple
stages)

t = tc Time

(pressure towards panic = (negative pressure released,

herding in bearish phase) progressively)

Negative bubble Negative anti-bubble

Extensions of the Log-Periodic Power Law model

From the perspective of complex

systems:

Rational expectation models

of negative bubbles
and anti-bubbles

US S&P500 Rational expectation bubble model

generalized Weierstrasssolution
with beta-function-type functions
of
the RG
(RG: renormalization group)

Rational expectation bubble model

with higher order solutions of the
RG
 Extensions of the Log-Periodic Power Law model

From the perspective of complex

systems:

Japanese Index: model and prediction

Rational expectation bubble model

second-order and third-order
with higher order solutions of the
Landau LPPL
RG

A. Johansen and D. Sornette, Financial “anti-bubbles”: log-periodicity in Gold and Nikkei collapses, Int. J. Mod. Phys. C 10(4), 563-575
(1999); Evaluation of the quantitative prediction of a trend reversal on the Japanese stock market in 1999, Int. J. Mod. Phys. C Vol. 11 (2),
359-364 (2000)
 Early  warning  of  the  2008-­‐20??  crisis
1945-1970: reconstruction boom and consumerism
1971-1980: Bretton Woods system termination and oil shocks /
inflation shocks
1981-2007: Illusion of the “perpetual money machine” and
virtual financial wealth D.Notenstein
Sornette and P. Cauwels, The Illusion of the Perpetual Money Machine,
Academy White Paper Series (Dec. 2012) (http://arxiv.org/abs/1212.2833)

2008-2020s: New era of pseudo growth fueled by QEs and

other Central Banks+Treasuries actions
-very low interest rate for a very long time (decades)
-net erosion even in the presence of apparent low (disguised) inflation
-reassessment of expectation for the social and retirement liabilities
-a turbulent future with many transient bubbles
-need to capture value and be contrarian => exploit herding and fear
2020s-20xx: Interconnection of many systemic risks
 The illusionary “PERPETUAL MONEY MACHINE”

rate of profit
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
transfer of wealth from populations
(young debtors buying houses
to financial assets (older sellers)
(Spencer Dale, Chief economist
Bank of England
savings

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 accumulation. FINANCE
consumption allows increasing debt and virtual wealth
growh... which can only be transitory (even if
very long).

United States Share of wages and of private

consumption in Gross Domestic Product
wages (GDP)
Source of data and graphics: http://
49
hussonet.free.fr/toxicap.xls
 The illusionary “PERPETUAL MONEY MACHINE”
• An economy which grows at 2 or
3 per cent cannot provide a
universal profit of 15 per cent, as
some managers of equities claim
and many investors dream of.

• Financial assets represent the

right to a share of the surplus
value that is produced. As long as
this right is not exercised, it
remains virtual. But as soon as
anyone exercises it, they discover
that it is subject to the law of
value, which means, quite simply,
that you cannot distribute more
real wealth than is produced.

From 1982 until 2007, the U.S. only experienced two shallow recessions that each lasted just 8 months.
This stretch of 25 years may be the best 25 years in the US economic history. But much of this
prosperity was bought with debt, as the ratio of debt to GDP rose from $1.60 to $3.50 for each $1.00 of
GDP. 50
 Predictability of the 2007-XXXX crisis:
30 year History of bubbles
and of Endogeneity
• Worldwide bubble (1980-Oct. 1987)

• The ICT (dotcom) “new economy” bubble (1995-2000)

Didier Sornette and Ryan Woodard,
Financial Bubbles, Real Estate bubbles, Derivative
• Real-estate bubbles (2003-2006) Bubbles, and the Financial and Economic Crisis
(2009)(http://arxiv.org/abs/0905.0220)

D. Sornette and P. Cauwels,

• MBS, CDOs bubble (2004-2007) The Illusion of the Perpetual Money Machine,
Notenstein Academy White Paper Series (Dec. 2012)
(http://arxiv.org/abs/1212.2833)

• Stock market bubble (2004-2007)

• Commodities and Oil bubbles (2006-2008)

• Debt bubbles
 6 months

7 years
Super-exponential growth

53
Real-estate in the UK

54
Real-estate in the USA

55
Our study in 2005
identifies the bubble
states

Local bubbles
(Froths) of
Housing
Markets in US,
1998-2006

56
Real-estate in the USA

W.-X. Zhou and D. Sornette, Is There a Real-Estate Bubble in the US?

Physica A 361, 297-308 (2006) (http://arxiv.org/abs/physics/0506027)
 Securitization of non-financial assets (commodities, real-estate, credit)

Estimated assets and market positions in

the hedge-fund industry from 1990 to 2008

One prominent financial figure held the greatest sway

in debates about the regulation and use of derivatives
— exotic contracts that promised to protect investors
from losses, thereby stimulating riskier practices that
led to the financial crisis. For more than a decade, the
former Federal Reserve Chairman Alan Greenspan
has fiercely objected whenever derivatives have come
under scrutiny in Congress or on Wall Street. “What
we have found over the years in the marketplace is
that derivatives have been an extraordinarily useful
vehicle to transfer risk from those who shouldn’t be
taking it to those who are willing to and are capable of
doing so,” Mr. Greenspan told the Senate Banking
Committee in 2003. “We think it would be a mistake”
to more deeply regulate the contracts, he added.

“Not only have individual financial institutions become less

vulnerable to shocks from underlying risk factors, but also
the financial system as a whole has become more resilient.”
— Alan Greenspan in 2004
bubble peaking in Oct. 2007

60
 2006-2008 Oil bubble
Speculation vs supply-demand

D. Sornette, R. Woodard
and W.-X. Zhou, The
2006-2008 Oil Bubble and
Beyond,
Physica A 388, 1571-1576
(2009)
(arXiv.org/abs/0806.1170)

Typical result of the calibration of the simple LPPL model to the oil price in US$ in shrinking windows with starting dates tstart
moving up towards the common last date tlast = May 27, 2008. 61
 CORN GOLD

R.Woodard and D.Sornette (2008)

SOYBEAN
WHEAT

62
 Energy and Agricultural Commodity Price Indices, 2000-2009

Abnormal
relationship
signaling a
bubble

Monthly Corn Price Index and

USDA Stocks
 Subprime Mortgage Loans Outstanding

Source: Inside Mortgage Finance.

 Wealth Extraction
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
equity debt outstanding less unscheduled
repayment on RMDO
Mortgage Equity Withdrawal
impact on GDP

source: John Mauldin (April 09)

Alan Greenspan and James Kennedy (Nov. 2005)
65
1981-2007: The illusionary “PERPETUAL MONEY MACHINE”
continues..

U.S. household debt as percentage of

gross disposable income. Reproduced from
McKinsey Quarterly, publication of the
McKinsey Global Institute, January 2012
 Total liabilities of the U.S. financial and non- financial sectors divided by the GDP

The data are taken from the Flow of Funds accounts of the U.S. (http://www.federalreserve.gov/
releases/z1/), the non-financial sector includes the federal government, government sponsored entities,
household and non-profit and non-financial business. The smooth curves show the fits of the models.

D. Sornette and P. Cauwels,

The Illusion of the Perpetual
Money Machine, Notenstein
Academy White Paper Series
(Dec. 2012) (http://ssrn.com/
abstract=2191509)

This picture demonstrates that debt levels are on unsustainable tracks that,
according to our bubble models, are expected to reach a critical point towards
the end of the present decade.
$ 50 trillions

68
THE GREAT MODERATION

source: U.S. Bureau of Labor Statistics.

 The Global Bubble
Index of
over-
valuation

The “perpetual money

machine” broke.

2003 2004 2005 2006 2007 2008 2009

PCA first component on a data set containing, emerging markets equity indices, freight indices, soft commodities, base and
precious metals, energy, currencies...

D. Sornette and P. Cauwels, The Illusion of the Perpetual Money Machine, Notenstein Academy White Paper Series (Dec. 2012)
(http://arxiv.org/abs/1212.2833 and http://ssrn.com/abstract=2191509)
 Predictability of the 2007-XXXX crisis:
30 year History of bubbles
and of Endogeneity
• Worldwide bubble (1980-Oct. 1987)

• The ICT (dotcom) “new economy” bubble (1995-2000)

Didier Sornette and Ryan Woodard,
Financial Bubbles, Real Estate bubbles, Derivative
• Real-estate bubbles (2003-2006) Bubbles, and the Financial and Economic Crisis
(2009)(http://arxiv.org/abs/0905.0220)

D. Sornette and P. Cauwels,

• MBS, CDOs bubble (2004-2007) The Illusion of the Perpetual Money Machine,
Notenstein Academy White Paper Series (Dec. 2012)
(http://arxiv.org/abs/1212.2833)

• Stock market bubble (2004-2007)

• Commodities and Oil bubbles (2006-2008)

• Debt bubbles
Financial Crisis Observatory
www.er.ethz.ch/fco
D. Sornette
P. Cauwels
Q. Zhang

72
 Financial Crisis Observatory
Zurich

•Hypothesis H1: financial (and other) bubbles can be

diagnosed in real-time before they end.

•Hypothesis H2: The termination of financial (and

other) bubbles can be bracketed using probabilistic
forecasts, with a reliability better than chance (which
remains to be quantified).
The Financial Bubble Experiment
advanced diagnostics and forecasts of bubble terminations

•Time@Risk: Development of dynamical risk

management methods
 Slaying dragon-kings
predictability and control of extreme events in complex systems

possibility to control by small targeted perturbations

Hugo L. D. de S. Cavalcante, Marcos Oriá, Didier Sornette, and Daniel J. Gauthier (2013)
 Big problems are piling up...
Suggested solutions:
• Study history (“this time is different”, really?)

• Recognition that crises are the norms rather than the exception

• Understand underlying mechanisms (positive feedbacks are grossly

under-estimated)

• Diagnostic: fundamental vs proximal

• Weak signal, advance warning and collective processes

• Monitoring and forecasting (managing and governing needs

predicting)

• Decouple and diversify

• Fiduciary principle; principled ethical behavior; reassessment of

expectations; risk monitoring

• Incentives + human cognitive biases + individual resilience

 Further Reading
D. Sornette, Dragon-Kings, Black Swans and the Prediction of Crises,
International Journal of Terraspace Science and Engineering 2(1), 1-18 (2009)
(http://arXiv.org/abs/0907.4290) and http://ssrn.com/abstract=1470006)

D. Sornette and G. Ouillon, Dragon-kings: mechanisms, statistical methods and empirical evidence,
Eur. Phys. J. Special Topics 205, 1-26 (2012)
(http://arxiv.org/abs/1205.1002 and http://ssrn.com/abstract=2191590)

D. Sornette and G. Ouillon, editors of the special issue of Eur. Phys. J. Special Topics on ``Discussion
and debate: from black swans to dragon-kings - Is there life beyond power laws?'', volume 25,
Number 1, pp. 1-373 (2012).
http://www.springerlink.com/content/d5x6386kw2055740/?MUD=MP

D. Sornette and R. Woodard Financial Bubbles, Real Estate bubbles, Derivative Bubbles, and the
Financial and Economic Crisis, in Proceedings of APFA7 (Applications of Physics in Financial
Analysis), “New Approaches to the Analysis of Large-Scale Business and Economic Data,” M.
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Didier Sornette, Why Stock Markets Crash (Critical Events in Complex Financial Systems) Princeton
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Y. Malevergne and D. Sornette, Extreme Financial Risks (From Dependence to Risk Management)
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