Wednesday, June 2, 2010

For Quant Geeks...

It was only a matter of time before research-level quants got their hands on the bubble question. Econophysicist Didier Sornette, at the Swiss Federal Institute of Technology in Zurich, has put together a model that tries to identify when an asset is in a bubble. The key, for him, is an asset or asset class exhibiting super-exponential growth: a rate of growth that's larger than an exponential rise. (On a a semi-logarithmic chart, this pattern would show as a line whose upwards slope increases over time) Once in that phase, it's only a matter of time before it changes into some other pattern - not necessarily a crash, but some other.

Sornette made four predictions six months ago, and gold was one of the asset class he identified as being in a bubble. He counted that prediction as a hit, because gold corrected. Two of his predictions were misses.

There's already criticism of the model, relating to the hindsight factor. Another, which popped up in a comment to the article, relates to "something else" being rather thin. Superexponential growth is a fragile pattern anyway, so it shouln't be much of a surprise to see it transform into something (anything) else.

A side note: Perhaps because there's less interest in the question, neither Sornette nor anyone else has devoted any attention to super-exponential decay or even regular exponential decay. At what point does capitulation end and the price trend reverse?...

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