Periodically we like to repost Didier Sornette's must read paper on general market instability, titled simply enough "Critical market crashes", which has shaped much of the Zero Hedge philosophy on market topology, microstructure, and general market themes. We present this without commentary as we do not wish to shape our readers' apriori perceptions. The 98-page paper is arguably just as important as any philosophical paper by Taleb when evaluating the scalability (and fragility) issues associated with modern market theory (or lack thereof). The paper, written in 2002, predicted many of the critical tensions prevalent in modern markets, and goes so far as to anticipate the fractal and chaotic behavior of the primary faux market makers exhibited in today's distorted market structure, a phenomenon recently proven from an empirical standpoint as discussed previously.
A key excerpt from the paper:
If large financial crashes are “outliers”, they are special and thus require a special explanation, a specific model, a theory of their own. In addition, their special properties may perhaps be used for their prediction. The main mechanisms leading to positive feedbacks, i.e., self-reinforcement, such as imitative behavior and herding between investors are reviewed with many references provided to the relevant literature outside the narrow confine of Physics. Positive feedbacks provide the fuel for the development of speculative bubbles, preparing the instability for a major crash. We demonstrate several detailed mathematical models of speculative bubbles and crashes. A frst model posits that the crash hazard drives the market price. The crash hazard may sky-rocket at some times due to the collective behavior of “noise traders”, those who act on little information, even if they think they “know”. A second version inverses the logic and posits that prices drive the crash hazard. Prices may skyrocket at some times again due to the speculative or imitative behavior of investors. According the rational expectation model, this entails automatically a corresponding increase of the probability for a crash. We also review two other models including the competition between imitation and contrarian behavior and between value investors and technical analysts. The most important message is the discovery of robust and universal signatures of the approach to crashes. These precursory patterns have been documented for essentially all crashes on developed as well as emergent stock markets, on currency markets, on company stocks, and so on. We review this discovery at length and demonstratehow to use this insight and the detailed predictions obtained from these models to forecast crashes.
Must read: Critical market crashes