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Why Stock Markets Crash: Critical Events in Complex Financial Systems

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Why Stock Markets Crash: Critical Events in Complex Financial Systems. Sornette, Didier Reviewer s: Santoni, Gary Published by EH.

Why Stock Markets Crash

NET April Didier Sornette, Why Stock Markets Crash: Princeton University Press, NET by Gary Santoni, Department of Economics, Ball State University. Why Stock Markets Crash by Didier Sornette is an interesting and thought-provoking book.

Why Stock Markets Crash: Critical Events in Complex Financial Systems by Didier Sornette — Reviews, Discussion, Bookclubs, Lists

Sornette is a professor of geophysics at the University of California, Los Angeles who specializes in the scientific prediction of catastrophes. Since stock market crashes are, without question, catastrophes, the reader might expect an informative treatment of the relationship between catastrophes that occur in the natural world and those that occur in financial markets.

Readers interested in why stock markets crash and the relationship between these events and natural catastrophes will be disappointed, however.

complex crash critical event financial in market stock system why

Clearly, natural and financial phenomena are similar in that catastrophes occur in both. It is something else to argue that the processes leading to these events and the relevant tools of analysis are the same or even similar.

George Stigler once noted that the economist faces a level of difficulty not shared by the physical scientist. Some would hurry him along; others would cry shrilly for a federal program to drill wells for water instead; and several would blandly assure him that they were molecules of argon. Few economists did more than Stigler to promote the application of science in economics but he warns that the economist can expect to encounter some special problems. Sornette bumps up against one of these special problems in his discussion of the fundamentals of stock prices.

Sornette fails to recognize that stock prices or, plus500 review forex peace army precisely, the choices people make in determining these prices are always based on expectations regarding the future — and this implies nothing about whether or not they contain a speculative bubble. Expected future cash flows dividends, capital gains, etc.

The behavior of people, unlike molecules of oxygen, is driven by expectations. This hypothesis implies that stock prices move at a random walk so that changes in the price are unpredictable. Since crashes are simply large negative changes in price, the hypothesis implies that crashes cannot be predicted. While the evidence that has accumulated over the years is largely consistent with ruplan kurssi forex idea, an interesting exception to this general result is noted in Chapter 3.

Examining daily data on the Dow Jones Industrial Average over the last century, Sornette finds 14 episodes — a total of 64 trading days out of a sample of about 25, — that violate the implications of the hypothesis. These unusual observations are all associated with large declines in stock prices ranging from The conclusion to be drawn from this is that stock prices behave unusually in the sense that successive changes in them may be related and, hence, predictable during episodes of large price declines.

There are several points that are important here.

These unusual episodes only occur during periods of large nepal stock market complex crash critical event financial in market stock system why. Second, there are relatively livestock market tazewell va of them — 64 of 25, trading days.

Third, the average length of these 14 episodes is only 4. Finally, these periods are only detectable after prices have begun to decline. For the vast bulk of the evidence Sornette analyzes particularly, when prices are generally risingchanges in stock prices behave randomly and, thus, are unpredictable. Perhaps because of the confusion regarding the role of expectations in economic decision-making, Sornette ignores the efficient market hypothesis and the evidence regarding it in the remainder of his book and focuses instead on various bubble models of stock prices all of which imply that prices behave unusually before a crash, i.

Sornette models the bubble with an equation containing a log-periodic correction to a power law for a variable stock prices exhibiting a finite-time singularity.

In short, Sornette attempts to fit a trend to stock prices for periods prior to crashes even though the data analyzed in Chapter 3 suggest that no such trend exists. As might be expected, the results are disappointing even though the test periods selected are those immediately preceding andthe two largest crashes on record. People will always be interested in stock market crashes.

If they were understood, it might be possible to forecast them which, of course, could lead to vast riches.

I wish Sornette good luck in his endeavor. George Stigler, The Theory of PriceMacmillan Company,p. Irving Fisher, The Rate of InterestMacmillan Company,p. Financial Markets, Financial Institutions, and Monetary History Geographic Area s: North America Time Period s: Net - Economic History Services.

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