Econophysicists Develop and Test "Bubble Index"

eldavojohn writes "Oh if only we could identify the bubble markets as they appear, but with all the random variables, it would take some sort of econophysicist to build predictions for that! Well, a team has released a definition of a 'bubble index' that led them to make predictions of bubbles six months ago that would pop between then and now. The four bubbles they selected were the IBOVESPA Index of 50 Brazilian stocks, a Merrill Lynch Corporate Bond Index, the spot price of gold, and cotton futures. Two out of the four were bubbles, with Merrill Lynch being a bubble already popping and cotton continuing to soar into even bubblier status. Still, for your first try, 50% isn't bad. The team learned a lot of new things from the first run, revised their method, selected their predictions for the next six months, and sealed them. Only time will tell if they are truly onto predicting crashes."

Comments

Self-fulfilling prophecies

[DavidR1991]

Does no-one see the problem here? If this becomes accurate to predict anything of actual use, the markets themselves will start using it... which renders the predictions themselves useless.

It's like seeing into the future and acting upon what you see - by doing that you alter the future itself, making the initial prediction invalid.

Re:Self-fulfilling prophecies

[doppe1]

But they don't want the bubble to happen, that's the point. By being able to predict that bubbles are happening, the markets can sell off sooner, rather than allowing the bubble to continue growing, and thus once the sell-off happens, it is not such a dramatic down-shift, since the prices were not allowed to rise to artificial highs.

Re:Self-fulfilling prophecies

[dkleinsc]

Except that they won't, for two reasons:
1. Investors are (collectively at least) really stupid. This has been proven time and again.
2. They think "this time, it's different. We know how to prevent this from becoming a bubble."

For instance, there were smart economists saying back in 2006 or so "watch out, there's a housing bubble". And what most of Wall St did was say "shut up, I'm busy counting my winnings".

Re:Self-fulfilling prophecies

[PPH]

The trouble then becomes selecting a group that we can trust with the wealth of nations, and the power to destroy by proclamation.

We could call it the Federal Reserve.

Re:Self-fulfilling prophecies

[ArsonSmith]

If the low is artificial, does that mean that the high is artificial?

yes it's all artificial based on the market's perceived value.

Quick simplified example.
Company takes in $1M in stock by selling stock and $1 a price. 100,000 people buy 10 shares each.

10 other people look at what the company is doing with that $1M and think it's a good idea and would be worth lots more so they start saying I'll pay $1.01 a share, $1.02 a share, $1.10 a share...etc until people start selling it. 100 more people see it start going up so they think there must be something going on and say I'll pay $1.20 a share, $1.30 a share, $2.03 a share etc... This is the time of the bubble when people that don't really do any investigation into the market but buy simply because it is going up. At some point there will be some more savoy investors come by and see that the stock is far to high and short sell a stock. A way of borrowing stock at a higher price then getting the difference when you return it at a lower price (or paying the diff if it goes up.) Eventually it'll come out that this company has only been able to turn the $1M into a $1.2M company and not the $2M+ that the market cap has it at and people will start to sell off. This is when the bubble pops.

There are other artificial things that can cause bubbles than just perceived value, like the government backed mortgages causing the real estate bubble.

Re:Self-fulfilling prophecies

[SashaMan]

In truth, identifying bubbles is actually remarkably easy. Famed investor Jeremy Grantham defines a bubble as a "3-sigma" event - that is, times when some fundamental ratio of value (such as P/E ratios, price-to-income ratios for housing affordability, price-to-rent ratios, etc.) - is more that 3 standard deviations above the mean for that ratio. Importantly, he showed that of 30-some odd historical bubbles, they ALWAYS popped, ALWAYS giving up more than 100% of the gains during the bubble period.

What is difficult, though, is trying to figure out WHEN a bubble will pop. The Nasdaq was far overvalued in mid 99 - that still didn't prevent it from DOUBLING in early 2000 before it burst.

Grantham also makes a good case as to why bubbles form. Tons of people in the financial world saw that risk was being underpriced in 2006/07. However, what would have happened if a CEO of a major bank would have said back in late 2005 / early 2006 "This is crazy, we're not going be backing these loans given to anyone who can fog a mirror"? That bank would have seriously underperformed its peers for the next two years, and that CEO would have been ousted long before his prudence would have been proven correct.

We don't need to predict them...

[davecb]

... in the years after the 2nd world war we used to treat every wild upswing as a bubble and increase the interest rates. Every downturn got a reduction in rates.

It was the same kind of negative feedback that engineers use to prevent oscillation (feedback squeals, for example).

You'll notice it worked. The converse worked much less well.

--dave

fifty percent is *NOT* bad

[ClickOnThis]

I'd rather predict 0%. That way I could reverse the predictions and get100%. 50% means a flip of a coin would work.

It depends on what you're predicting 50% of. If you predict 50% of the winners of a horse race, then half the time you're choosing the right horse. You could probably make a living at the track. On the other hand, if you predict 0% of the winners, you'll go broke betting on the other 9 horses all the time.

Now, instead of 10 horses, imagine hundreds of companies traded on the stock market...

Another Tool To Ignore

[cmholm]

Having a new model/metric to play with is nice. But, it wouldn't have made a damn bit of difference with the most recently departed "phantom value". The core issue is that when people are making a lot of money off a hot economic streak, rich people in particular, there's a strong incentive to not screw with the gravy train. Hell, The Economist, for one, had spent three or four years publishing charts and stories suggesting that the western European/North American real estate bubble was unsustainable, and due for correction.

The missing bit of information was exactly what the corrective signal was going to be. The US Federal Reserve - in the person of Mr. Greenspan - could have provided it, but the Fed board is full of conservative bankers that didn't want to rock the GOP's boat. The various Wall Street bankers could have provided it, but instead they were busy putting out increasingly meta-physical financial products to squeeze another round of bonuses out of the market. So instead, they were all Cosmo Kramer, joy-riding the Saab down the expressway for as long as the fumes kept it going.

It doesn't matter what predictive tool you've got, even the Word of the Lord wasn't and isn't going to stop people from trying to grab that extra [your monetary goal here], if there's any money left on the table.

Re:Color me skeptical

[ImABanker]

Having read the paper, this is more ridiculous than I initially suspected. Of the four assets that they identified as being "bubbles", all four increased in price since they made the prediction! The only way to ultimately determine if a bubble is a bubble and not a rational increase in prices is by the subsequent collapse. They try to hedge themselves by saying that it changed into "some other sort of regime", ie non-hyper-exponential growth. So if it is flat, or down, or up they are correct. The only instance they claim to be able to predict is that the asset will not increase hyperexponentially. And they even fail at this, in the price of cotton. Sadly, can claim some knowledge in the realm of finance.