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Didier Sornette: How We Can Predict The Next Financial Crisis

Tyler Durden's picture




 

Three years ago we discussed the details of Didier Sornette's approach to identifying bubble-like characteristics of price evolutions. In this brief TED talk, the bubble-whisperer combines behavioral finance with risk management with his super-exponential model view of the world that "we have been operating under a few detrimental illusions that have landed us in our current economic state."

 

 

Via TED blog,

The 2007-2008 crash seemed to come out of nowhere, with no source or group to take responsibility, an unpredictable one-time anomaly — as Sornette calls it: “the wrath of God.” But as he says firmly: Despite what standard risk management tools show, these outliers operate under special mechanisms that make them predictable, perhaps even controllable. Sornette and his team at the Financial Crisis Observatory (FCO) call these special cases “dragon-kings.” Dragon-kings, in direct contrast with “black swans,” are at the core characterized by a slow maturation of instability, which move toward a bubble, until the bubble reaches a climax and bursts.

There are many early warning signs of dragon-kings, but one of the crucial ones is super-exponential growth. Super-exponential growth is trenchant and unsustainable and can be found in many areas of study to predict dragon-kings. Sornette has applied it to Ariane rockets, parturition problems, epilepsy, landslides, even blockbuster movies and YouTube virality.

Dragon-king theory can be applied to 30 years of financial bubble history, starting with the worldwide bubble that started in 1980 and popped in 1987, and ending in the most recent global over-valuation bubble that broke in 2007 and 2008. In December 2007 Sornette predicted the Chinese market bubble, to the disbelief of analysts. Three weeks after his presentation the markets lost 20 percent, and by the end of the year they had lost 70 percent.

Can the dragons be slain? In a way. Learn the art of planning and predicting, says Sornette. If we find pockets of predictability, advanced diagnostics of crises are possible. So that crises may never again take us by such surprise.

 

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Tue, 07/02/2013 - 00:52 | 3712802 RockyRacoon
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Yeah, just like that.  What comes of population rises like that is the proliferation of plagues and such.  The problems get fixed, whether by Dragons or Swans.  Remember the old science experiments where they crowded more and more rats into the same cage?  The outcome was not pretty.  They talk in glowing terms about the "growth" of Africa in the future.  How its population of 1 billion will become 2 billion in just a generation or two.  That's one spooky outlook.

Mon, 07/01/2013 - 21:02 | 3712129 Cognitive Dissonance
Cognitive Dissonance's picture

I would argue that we never left the last "crisis", thus there's no need to predict the next one. We're already there and in fact never left.

The proof is that the Fed is still using heroic efforts under extraordinary and emergency conditions.

Mon, 07/01/2013 - 21:02 | 3712137 fonzannoon
fonzannoon's picture

CD I believe this comes back to the idea of the market vs the actual economy.

Tue, 07/02/2013 - 00:53 | 3712805 RockyRacoon
RockyRacoon's picture

We did get to see who was swimming naked.  The problem is, the participants never got out of the water when the tide went out.  They just stayed in with their hands over their private parts.  Pretty soon the charade will end.

Tue, 07/02/2013 - 01:58 | 3712925 Fox Moulder
Fox Moulder's picture

ZIRP, $85 billion a month, etc are normal.

 

And we have always been at war with Eurasia.

Tue, 07/02/2013 - 12:15 | 3714243 XitSam
XitSam's picture

Nixon removing (what was left of) the gold standard in 1971 was "temporary".

Mon, 07/01/2013 - 21:02 | 3712136 icanhasbailout
icanhasbailout's picture

Why bother thinking about the next financial crisis when we're still undergoing the last one?

Mon, 07/01/2013 - 21:03 | 3712138 Dr Benway
Dr Benway's picture

Crises that do not take us by surprise?

Kind of like oxymorons that aren't self-contradictory.

Mon, 07/01/2013 - 21:05 | 3712149 Iam_Silverman
Iam_Silverman's picture

Why always flying things?  Black swans, Dragons.  Why not pigs?  Yeah, let's look for pigs in the economic jumble.  And then when pigs fly........

Mon, 07/01/2013 - 21:40 | 3712248 Zadok
Zadok's picture

Then we will require structurally reinforced umbrellas...

Mon, 07/01/2013 - 21:06 | 3712153 impermanence
impermanence's picture

As long as there are groups, there will always be financial crises, which is, of course, simply another way of stating that there are a small group of people always willing to do whatever it takes to steal from the rest.

Mon, 07/01/2013 - 21:21 | 3712188 chump666
chump666's picture

We are still primates. 

Mon, 07/01/2013 - 22:27 | 3712375 Sun and Moon
Sun and Moon's picture

Are we not men?

Mon, 07/01/2013 - 21:28 | 3712208 mpath
mpath's picture

Combining this method for longer term turns seems like a great way to manage accounts. Shorter term-follow the institutions all different time frames. Easy money. 

 

http://www.thefinancialinc.com/free-mpmel-page/

 

Mon, 07/01/2013 - 21:36 | 3712237 eddiebe
eddiebe's picture

Fiat and sovereign bonds bubble waiting for pin.

Mon, 07/01/2013 - 21:37 | 3712240 Raymond_K_Hessel
Raymond_K_Hessel's picture

Oh, cool, so you have a way of forecasting the major near-term market moves in a way that allows you to vastly out perform the markets on a risk-adjusted basis? Wow, with the kind of power you claim to possess you would become the most wealthy person in the world in a few years...

Tue, 07/02/2013 - 00:56 | 3712811 RockyRacoon
RockyRacoon's picture

There are those who value scholarly pursuit above fortune.  Really.  It's true.  Your statement reveals your narrow world view.

Tue, 07/02/2013 - 08:10 | 3713291 Raymond_K_Hessel
Raymond_K_Hessel's picture

You can keep your ivory tower. I'll keep living in the real world where money talks and bullshit walks.

Tue, 07/02/2013 - 23:37 | 3716653 RockyRacoon
RockyRacoon's picture

I'm just saying that you can't group everyone into little convenient niches.   I'm an educated person who spent my whole life in construction and the mechanical trades.  I found a good general education to be invaluable.  Didier Sornette presented his ideas to the financial markets and got crickets.  Why?  Because those in attendance had that same straight-jacket that you describe.  There are Ivory Towers of finance as well!

Tue, 07/02/2013 - 08:24 | 3713332 Inspector Bird
Inspector Bird's picture

Actually, while I agree some value scholarly pursuit, there's the additional flaw he left undiscussed. If everyone listens to him, the market is non-existent. He may be right, but even in being correct, if people adopt his solutions en masse, there is money to be made in a contrarian philosophy. In the event, he has 'fixed' nothing and simply shifted the market.

Still, there is always some value in the study so you have more strategy options.

Tue, 07/02/2013 - 23:40 | 3716659 RockyRacoon
RockyRacoon's picture

You can rest assured that everyone will not listen to him.  There's no money in it.  It was known here at ZH long before the housing bust.  Why did so many get caught flat-footed?  I don't think Didier Sornette is out to "fix" anything at all.  It's just the results of research that get ignored.   We know what happens in lots of social experiments, many of which we repeated in college level psych classes, but we still do the same old stupid shit.

Tue, 07/02/2013 - 08:27 | 3713333 Inspector Bird
Inspector Bird's picture

*

Mon, 07/01/2013 - 21:41 | 3712249 MedicalQuack
MedicalQuack's picture

This scares me with software now we have a Quant platform where anyone can toss algorithms out on the exchanges..they have a testing environment too but perhaps one might ask Knight Capital about that for a 2n dopinion ...yes indeed tossing some new algorithms out there from anyone who can build and test a model..that will do it..

https://www.quantconnect.com/

Dr. Sean Gourley actually tweeted this link above and he has a good TED video here on the markets...

http://ducknetweb.blogspot.com/2012/08/high-frequency-trading-algorithm....

Mon, 07/01/2013 - 21:42 | 3712250 DOGGONE
DOGGONE's picture

Snowden has this. Do you expect him to show/tell ...?
http://www.showrealhist.com/RHandRD.html

Mon, 07/01/2013 - 21:44 | 3712252 doggis
doggis's picture

I TAKE YOUR "DRAGON KINGS" AND RAISE YOU A "HORSE SH*IT!"

RANDOM, BUBBLES, DRAGON KINGS - ARE YOU F*CKING KIDDING ME.

ALL MODERN DAY CRASHES ARE PLANNED!

COME ON, LIBOR FIXING, ISDA FIXING, FX FIXING - MANIPULATION OF PRICES ON A GLOBAL SCALE. AHHH HELLOOOO "LABOUR IS A PRICE TOO" AND THE PRICE OF LABOR IS BEING MANIPULATED TOO!

CRASHES ARE PLANNED AND ACT AS A SEQUESTER OF THE MUPPETS FUNDS......THE SAME FUNDS  THAT PAY FOR CONSTRUCTING OF ENERGY AND TELECOMMUNICATIONS OF THE INFRASTRUCTURE OF -LET'S SAY INDIA. [can anyone say ENRON]...... HOW ELSE CAN THEY OUTSOURCE YOUR JOBS ABROAD.

YOU PAY FOR YOUR OWN JOB DESTRUCTION! FOLLOW THE PLAY BOOK.

***********************************************

ARE THEY DOING IT NOW....DAMN RIGHTS THEY ARE! LOOK TO AFRICA AND FURTHER DEVELOPMENT OF INDIA. [can anyone say blackstone, kkr, carlyle group].

ANOTHER SEQUESTER IS AROUND THE CORNER!!! and with it - more job losses!!! oops.

DRAGON KING - MY ASS!

 

 

Mon, 07/01/2013 - 22:23 | 3712362 sbenard
sbenard's picture

I get it! You're outraged!

But frankly, I think you've thrown out the baby with the bathwater. After both reading Sornette's book, and viewing the entirety of this video, I don't see your theory that these events are planned, as being mutually exclusive to Sornette's ideas that they are also predictable.

As I view what the Fed is doing, I find it increasingly difficult to believe that they can have so much hubris that they can simply deny or overlook the bubbles they are creating. I am more convinced with each day that these bubbles and the resulting crises are planned. But I have no proof. And honestly, neither do you.

But we as individual investors, if we study the science behind Sornette's ideas, can learn to recognize those bubbles and thereby avoid being one of their casualties. I expect that politicians, Keynesian kooks, and government central planners will ALWAYS miss the warning signs. But that doesn't mean WE have to.

If we listen and learn from Sornette, we'll be better investors, and will avoid the crashes that result. THAT, I believe is the point he's making.

And I said it all without SCREAMING... much! :)

Tue, 07/02/2013 - 01:00 | 3712823 RockyRacoon
RockyRacoon's picture

What one does not understand, he blames on conspiracy.  Simple human nature, just like why investors don't get out when they know they should.   Not stupidity actually.  Just regular old human nature.  I think one of the terms used is normalcy bias, and there are probably a dozen others.  Most men can deny the obvious in the face of contrary evidence.  Money is one of the motivating factors -- there are others.

Tue, 07/02/2013 - 04:28 | 3713009 Lore
Lore's picture

It's important to distinguish between crises that really come out of left field, and those that are filtered and/or manufactured by crisis creators.  For the most part, bubbles are a symptom of attempts by one group to gain and hold power over another. Enough said?

Tue, 07/02/2013 - 23:41 | 3716663 RockyRacoon
RockyRacoon's picture

You are probably right, and that power comes in the form of financial gain.

Tue, 07/02/2013 - 09:48 | 3713657 Inspector Bird
Inspector Bird's picture

I'm not sure we can avoid crashes.  We, perhaps, can mitigate them by investing less on momentum and 'gut' and using strategies which conform with older, and more established methods of investment (cash flow, EBITDA, price/forward earnings, etc.).  Investing based on fundamentals makes sense, and while it is not foolproof, it does ramp up less quickly than momentum investing, which is designed to make a quick buck (or lose it just as fast).

Rigged?  Markets can be rigged, but that matters little.  If you don't know it's rigged, it only matters to those who know it.  Sometimes, even in rigging it, they wind up losing.  The key is just being smart and being informed, and Sornette's information helps keep us informed properly.

As I mentioned above, the problem rests in 'everybody' adopting his philosophy, which degrades the differentiation in markets which create profit or loss, or opens up opportunities for contrarian views.  In either case, the 'problem', such as it is, is not removed, but merely altered.  Possibly the timing, possibly the scale, possibly creating other 'problems' which we do not yet realize exist.  I'm not saying Sornette is wrong or not worth listening to, quite the contrary.  His information is useful to investors.  But the government, and government facilities (like the Fed) would damage the system if they implemented any 'tools' to offset these Dragon Kings, because they'd be messing with the market - essentially assuming they are smarter than the market as a whole.  This is a fool's game.  The whole point (which I believe the original poster alludes to) is that crashes, while perhaps not deliberate, are the result of humans thinking they are smarter than the market as a whole, and trying to produce specific outcomes (long term, low inflation, growth without any consequences) and not realizing in trying to reduce risk but maximize growth they have actually increased long-term risk.  So why would a problem, caused by a man-made 'solution', be potentially mitigated by another man-made 'solution'?  It wouldn't, because we simply can't know the potential outcome(s).

But as information and offering potentials for investing strategies, Sornette has developed a very useful tool and one which every investor should pay attention to because it increases opportunities.

Mon, 07/01/2013 - 21:44 | 3712253 Atomizer
Atomizer's picture

Our Dagorn Knigs are rkaramleby rsubot. We hvae a ptepuaerl troguh of steaucnnse to miaantin ulfiinang bulbbes to iejnct fulrcleofy form the raer of our atomibuloe. Prctoneijg seepds to redner enacetpxts can be moutldaed thhguot gas padel aeaclcteiorn or wseierlsly hciakng itno the bkraes to lcok wleehs and aovid crsah.

Mon, 07/01/2013 - 21:46 | 3712257 fonzannoon
fonzannoon's picture

wow

Tue, 07/02/2013 - 01:02 | 3712829 RockyRacoon
RockyRacoon's picture

Each word is its anagram.  I'm not impressed.

Mon, 07/01/2013 - 22:27 | 3712369 sbenard
sbenard's picture

Perhaps this person's hands were unfortunately transposed on the keyboard. I've been known to do that a time or two (...or three). I'm trying to give them the benefit of the doubt.

That said, this comment was incomprehensible to me, and I'm not going to take the time to try to translate it!

Mon, 07/01/2013 - 22:41 | 3712418 SunRise
SunRise's picture

Maybe he's transposing our eyes instead of his hands.  If so, I'd bet he could predict the next bubble.

Mon, 07/01/2013 - 21:48 | 3712264 Atomizer
Atomizer's picture

Woo. I think the dialect was a tad too strong. Will work on that later. /hehehehee

 

Mon, 07/01/2013 - 21:57 | 3712281 sbenard
sbenard's picture

I just recently read Sornette's very esoteric book, Why Stock Markets Crash. I learned of Sornette while reading Dr. John Hussman's weekly market commentary. I had to get Sornette's book via interlibrary loan from a university library. It had only been checked out by THREE people in the ten years since it was published. I guess the cryptic language and math scared even many university finance majors away. :)

It was filled with arcane mathematical formulas and data, but the message was clear to me that the Fed has created another stock market bubble, and both investors and Wall St are ignoring the risk, thereby increasing that risk. Sornette explains in various sections of the book that there ARE numerous predictable and recurring signs of bubbles and red flags for when to expect a crash. We're being set up for the next crisis and crash! It's arrival is as certain as daylight follows the night, and the perception in the markets that all risk has been removed by central bankers, is a major sign and contributing factor in enhancing that risk and the resulting collapse.

Thanks for posting this. I recommend Sornette's writings to all! Just don't expect them to be an easy read.

Tue, 07/02/2013 - 01:05 | 3712836 RockyRacoon
RockyRacoon's picture

I've read James Joyce, Charles Darwin, Chaucer, and William James among others.  This can't be that bad.

Can it?

Mon, 07/01/2013 - 21:54 | 3712283 lieto
lieto's picture

The internet bubble, the bubble in real estate were not hard to see.

The sovereign bond bubble or rate bubble (the mother of all bubbles) isn't hard to see either.

It looks like we are in real trouble here.

It gives me the chills when considering where we are at now.

CD's correct but TPTB have spent 5 additional years digging a much deeper hole than we started with.

Then they are congratulating themselves on saving the world?

It's more like keeping a patient on life support until a shift change then claiming that they didn't die on your watch.

 

Tue, 07/02/2013 - 07:21 | 3713175 Go Tribe
Go Tribe's picture

When will the government bubble burst?

Tue, 07/02/2013 - 10:15 | 3713766 Coldsun
Coldsun's picture

History tells us it will occur when there are enough little people willing to pop it. Don't expect that to happen when the middle class comforts and free goodies are still the norm.

Mon, 07/01/2013 - 22:25 | 3712368 Sun and Moon
Sun and Moon's picture

So many possibilities to choose from:

1. Eurozone

2. Japan

3. China

4. Bond bubble

Which one will blow up first? Or will they all blow up together?

Mon, 07/01/2013 - 22:27 | 3712377 q99x2
q99x2's picture

I liked the chaos theory aspect.

I'm trying to figure out how something that has its roots in criminal FRAUD becomes predictable when there are none, nada, zero, no facts that are known and like C. Diss said the crisis has from 2008 has not stopped.

So what's the point. I mean does anyone think this excellent presentation makes that guy look like anything other than a fucking moron? Hope no one was stupid enough to give the guy money.

Mon, 07/01/2013 - 22:30 | 3712384 Bindar Dundat
Bindar Dundat's picture

What the fuck is this frog talking about?

Mon, 07/01/2013 - 22:46 | 3712435 Atomizer
Atomizer's picture

In a nutshell, he is telling you that the sun will rise in the east and set in the west. All of his math models predict the continuing trends. The only red flag, we may experience a 10 to 30 second variant in time vs. the atomic clock measurements.

/sarc

Mon, 07/01/2013 - 22:41 | 3712417 slimething
slimething's picture

In the meantime, BTFD.

Mon, 07/01/2013 - 22:46 | 3712436 assistedliving
assistedliving's picture

nothing of interest.  gimme a list of the top ten shorts so he can throw a hangin party.  he prefers that to making $$$ w/ his dragons.  when u serve me the list gimme a break chaser

Mon, 07/01/2013 - 23:36 | 3712627 Flakmeister
Flakmeister's picture

How can we predict the next financial crises??

3..... 2.... 1....

Is that good enough?

Tue, 07/02/2013 - 00:39 | 3712775 starman
starman's picture

I think Cramer is a fucking dragon king or drag queen of a shit or something!

Tue, 07/02/2013 - 01:54 | 3712921 PT
PT's picture

How can we predict the next bubble?  When someone earning 14 grand per year has repayments of fifty grand per year?  No?  How about 100?  200?  No?  Well, I guess bubbles really are unpredictable then.

Pardon me, I need to go and puke.

Tue, 07/02/2013 - 07:27 | 3713197 Snoopy the Economist
Snoopy the Economist's picture

What friggin crap. I watched the video and thought it interesting and really expected it to end with a prediction as to when it would all come crashing down...I was disappointed with no prediction.

Tue, 07/02/2013 - 20:37 | 3716021 Promethus
Promethus's picture

I think common sense and a simple measure are the best methods to detect bubbles. I suspect anything that grows by more than 6% after inflation for three or more years to be a bubble. You get a lot of false positives but there is no heavy lifting for the math.

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