One of the world's most powerful supercomputers, retrofitted for trading the stock market, appears to be betting on a crash in the months ahead.
The Financial Crisis Observatory (FCO) at ETH Zurich released its latest Global Bubble Status Report on July 1st.
As we discussed with FCO’s director, Didier Sornette, on our podcast in May, they use one of the world’s leading supercomputers to monitor global markets each day for two distinct bubble-like characteristics: faster than exponential price movement and accelerating oscillations .
[ZH: We first discussed Sornette's work in 2010 on identifying "critical market crashes", and again in 2013 when Sornette explained "how we can predict the next financial crisis" to a TED audience...
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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Sornette's July report notes an increasing trend of positive bubbles across multiple asset classes.
Here’s what they say in their “big picture” section:
“One can observe the continuation of a trend in the growth of positive bubbles in the fixed income asset class for the second month. The fraction of stocks diagnosed in a positive bubble state increased this month to exceed 36% compared with 32% last month. Mixed bubble signals still occur only in few commodity indices. We also observe renewed bubble activity in currency pairs.” [source]
Here is the chart where they show the “historical evolution of the fraction of assets within an asset class that show significant bubble signals”:
A positive bubble signal is an indication of herding when people start buying because prices go up. A negative bubble signal is an indication of herding when people start selling because prices go down.
Based on their daily scan of global markets, the Financial Crisis Observatory assigns individual stocks into four different quadrants based on their bubble strength and value score. These four quadrants are then used to create a trading strategy consisting of four different portfolios, which they define as follows (click image to enlarge):
In looking at each of the four portfolios, it appears that the supercomputer was mostly initiating long positions since March. However, starting in June, the researchers note that there has been a rebound in Contrarian Short portfolios in recent weeks:
“This month, we find that Long portfolios started to develop a drawdown in most portfolios initiated in March, April, May and June 2017. This reflects the stopping of the previously booming markets. Especially, the Contrarian Short portfolios rebounded in recent weeks. Contrarian Portfolios are more delicate to use due to their sensitivity to timing the expected reversal and exhibit very volatile performances, indicating that most of bubbles in the market are still dominating and that fundamentals have not yet played out. We expect trend-following positions to perform in the months following the position set-up and then contrarian positions to over-perform over longer time scales as the predicted corrections play out.”
Here is a chart illustrating each of their four portfolios since June with the rebound in Contrarian Shorts shown in green, which they expect to “over-perform over longer time scales as the predicted corrections play out.”
Based on the large and growing list of positions in its Contrarian Short portfolio—which includes the FANG stocks—it would appear that FCO's supercomputer is setting up for some sort of market crash or correction in the months ahead.