Why Stock Markets Crash: Critical Events in Complex Financial Systems

by Didier Sornette

Book Overview

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.

• Format: Paperback
• Language: English
• ISBN: 0691118507
• ISBN13: 9780691118505
• Release Date: March 2004
• Publisher: Princeton University Press
• Length: 448 Pages
• Weight: 1.43 lbs.
• Dimensions: 1.1" x 6.0" x 9.3"

Customer Reviews

An Engaging and Thought-Provoking Work

If you love to read works on economics, math and physics and love to assemble models of the world, I cannot recommend this book highly enough. Indeed, if economic models were this much fun when I was an undergraduate, I might have become an economist.Funny thing though, this was not written by an economist, but by a geophysicist.It seems physicists and psychologists in particular are writing more interesting economics books these days than economists themselves. The core focus of the book is a derivation of a market model that includes value investors, momentum investors and the herding effect of individual economic agents acting in a world of partial information. The final model is stunning.Sornette points out the main problem with predicting bubbles: even if all the signs say "yes," there is still a pretty good chance that the bubble will be self-correcting. Turns out chasing market bubbles is a little like chasing soap bubbles - they may simply disappear at any moment. Thus, the book and the model are of limited use in any type of market timing. Indeed, the model suggests that the market should now be in the tank, and yet it continues to hover on the higher side of its expected range.As much as I loved the book, there was a slight aftertaste that this was all nothing but a very mathematical and high-minded type of technical analysis. That at base, when all was said and done, this was not all that different from the various "tools" in the chartist's handbook, e.g. MACD, RSI and OBV, etc., etc., etc. The difference may be solely that Sornette knows his statistics and would easily and readily dismiss any model which did not perform significantly different from chance. Finally, this book will have you trotting out your old high school calculus book. It brought back memories of just how much fun mathematics can be.All in all - I give it 5 stars.

One of the best books on finance ever

This is a fascinating book, both on finance and many other complex phenomena. I have now read it three times.It appears he has made a genuine advance in understanding financial bubbles and crashes. However reading the book does require that you are prepared to think. If you are after someone telling you what to buy or sell, this is not the book for you.Yes there is some math but you really can skip it without losing too much. The quotes that people have included in their reviews are minor asides that merely point the interested to further related material.Some others have commented that his predictions have not all worked out. This is all discussed at length in the book; in such a field predictions are not infallible. About 40% of market crashes are caused by external events and so are not predictable. However he seems to have the S & P500 worked out. Last years he predicted a choppy rally in 1Q2003, then from 2Q2003 a major fall ending in 1h2004. So far so good.

Why Stock Markets Crash

Didier Sornette has written an elegant and penetrating study of the complex elements which contribute to financial booms and their associated busts. Its most important conclusion is that potential crashes are proceeded by statistical "fingerprints", largely independent of the particular markets involved, which permit their timing to be estimated within narrow limits by mathematical modeling, as demonstrated by numerous examples. The book attempts two difficult challenges: first to model the potential timings of instabilities conducive to crashes in financial markets, and second to describe both the resulting models and their underlying phenomena intelligibly to the lay reader unfamiliar with much, or even all, of the mathematics involved. I found the author remarkably successful on both counts. The book reads uncommonly well provided one does not get distracted by the inevitable unfamiliarity of some of the mathematical terms, and in support of its main argument presents a wealth of interesting and uncommon information. Importantly, it also reflects a familiarity with the realities of financial markets, typically lacking in academic studies of market phenomena. This appraisal will not be shared by all readers. If you are a fan of Kramer and Kudlow or prefer information about financial markets in sound bites from CNBC, or if you are looking for specific guidance on how to make money in markets, this book is not written for you. Furthermore, the book contains references to a considerable amount of serious mathematics which is likely to annoy some fraction of its readership. This can be circumvented, as suggested, by simply skimming whatever is unfamiliar. What is missed will have been addressed to a different audience, and not much of relevance will be lost. However, if you are frustrated by (or hostile to) unfamiliar mathematical terms and references, however inessential to the gist of the argument, best give it a pass.For the rest, this is a deep study of engaging interest which repays more than one reading.

You can skip the math and still learn a lot.

Why Stock Markets Crash by Didier Sornette is an interesting book. He is a geophysicist who specializes in predicting failures in complex systems.The book contains some rigorous mathematical proofs for a 'popular' book which means it probably won't be popular. But even if one merely glances the math, which again is mostly for proofs and for those with an analytical inclination, the overall text and thoughts and analysis are extremely thought provoking and insightful.Its really good. You should read it if you have a background in stats or finance and are interested in the theory of efficient markets and the occurence of 'secular' events.

Experiment by yourself

I must confess that I readDidier Sornette's book with much pleasure; and I alsoread the reviews posted on this site in particular those who contend that, unless you are Stephen Hawking, you will be unableto grasp the message the book conveys. Well, as I'm notHawking this opens a debate which isworth some moments of reflexion.Before seventeenth century physicists unraveled the mysteriesof vacuum and atmospheric pressure, the accepted explanation,we are told, was that "nature is averse to vacuum". Obviously,such an anthropomorphic explanation is both easy to grasp andintuitively appealing. Although based on a number of niceexperiments, the scientific framework which replaced it didnot have the simplicity and intuitive attractiveness of theformer statement.Why do stock markets crash? Well, the answer is very simple.Because investors are averse to uncertainty, because of an abrupt change in their mood and overall utility function. OK. But unless, we can assess and measure in some objective and quantitative way either market uncertainty or the investors' global utility function, we will not govery far with such kind of explanations. Now, let us come back to Didier Sornette's book. The authorproposes a new framework which is based both on a set of new ideas and new scientific tools. As to the ideasone can mention the two following. * Stock market boom-crashes are a recurrent process,which implies that they can be studied from a comparativeperspective. Specifically this means that it makes senseto compare the crash of the Paris stock market in 1881and the crash of the NASDAQ market in March 2000. * What happens on stock markets is the result of theCOLLECTIVE BEHAVIOR of agents which means that thedecision which I take today depends upon what my friends or colleagues David, John and Stanley have done (and vice versa). Simple as they may seem, these two ideas are quite innovative. Even in the circle of behavioral economistsfew (if any) researchers would probably accept themaltogether. Naturally, in order to translate these ideas intoworkable models we need some mathematical tools. Is it at that point that I need to be Hawking? I don't think so. Discrete scale invariance or log-periodicity techniques arenot more complicated than modern theories ofequity arbitrage or Ito's lemma (which is used in continuous time arbitrage theory), but these techniquesare less familiar to us and we therefore need some timeto get acquainted with them. Through numerous figures and graphs this book provides an introduction to these techniqueswhich is aimed for newcomers and pedestrians.Of course, you don't need to take my view as gospel truth, just experiment by yourself.