Why Stock Markets Crash: Critical Events in Complex Financial Systems

Why Stock Markets Crash: Critical Events in Complex Financial Systems

Why Stock Markets Crash: Critical Events in Complex Financial Systems

Why Stock Markets Crash: Critical Events in Complex Financial Systems

Synopsis

The scientific study of complex systems has transformed a wide range of disciplines in recent years, enabling researchers in both the natural and social sciences to model and predict phenomena as diverse as earthquakes, global warming, demographic patterns, financial crises, and the failure of materials. In this book, Didier Sornette boldly applies his varied experience in these areas to propose a simple, powerful, and general theory of how, why, and when stock markets crash.


Most attempts to explain market failures seek to pinpoint triggering mechanisms that occur hours, days, or weeks before the collapse. Sornette proposes a radically different view: the underlying cause can be sought months and even years before the abrupt, catastrophic event in the build-up of cooperative speculation, which often translates into an accelerating rise of the market price, otherwise known as a "bubble." Anchoring his sophisticated, step-by-step analysis in leading-edge physical and statistical modeling techniques, he unearths remarkable insights and some predictions--among them, that the "end of the growth era" will occur around 2050.


Sornette probes major historical precedents, from the decades-long "tulip mania" in the Netherlands that wilted suddenly in 1637 to the South Sea Bubble that ended with the first huge market crash in England in 1720, to the Great Crash of October 1929 and Black Monday in 1987, to cite just a few. He concludes that most explanations other than cooperative self-organization fail to account for the subtle bubbles by which the markets lay the groundwork for catastrophe.


Any investor or investment professional who seeks a genuine understanding of looming financial disasters should read this book. Physicists, geologists, biologists, economists, and others will welcome Why Stock Markets Crash as a highly original "scientific tale," as Sornette aptly puts it, of the exciting and sometimes fearsome--but no longer quite so unfathomable--world of stock markets.

Excerpt

Like many other people, I find the stock market fascinating. The market's potential for lavish gains and its playful character, made more attractive with the recent advent of the Internet, resonates with the gambler in us. Its punishing power and unpredictable temper make fearful investors look at it sometimes with awe, particularly at times of crashes. Stories of panic and suicides following such events have become part of market folklore. The richness of the patterns the stock market displays may lure investors into hoping to “beat the market” by using or extracting some bits of informative hedge.

However, the stock market is not a “casino” of playful or foolish gamblers. It is, primarily, the vehicle of fluid exchanges allowing the efficient function of capitalistic, competitive free markets.

As shown in Figure 0.1 and Table 0.1, the total world market capitalization rose from $3.38 trillion (thousand billions) in 1983 to $26.5 trillion in 1998 and to $38.7 trillion in 1999. To put these numbers in perspective, the 1999 U.S. budget was $1.7 trillion, while its 1983 budget was $800 billion. The 2002 U.S. budget is projected to be $1.9 trillion. Market capitalization and trading volumes tripled during the 1990s. The volume of securities issued was multiplied by 6. Privatization has played a key role in the stock market growth "51". Stock market investment is clearly the biggest game in town.

A market crash occurring simultaneously on most of the stock markets of the world as witnessed in October 1987 would amount to the quasi-instantaneous evaporation of trillions of dollars. In values of . . .

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