Irrational Exuberance. LPPL signatures in EUR/PLN

People like to go to excesses. I think that what started out with a tulip, maybe four-hundred years ago, and continued through the South sea bubble and all of those sorts of things ( Tronic bubble in 60’s, new economy bubble in 90’s). I’m not saying here that that all human choices are orthogonal to rational ones but in human nature is to heard. Herding can result from a variety of mechanisms, such as anticipation by rational investors of noise traders strategies, agency costs and monetary incentives given to competing fund managers, sometimes leading to the extreme Ponzi schemes, rational imitation in the presence of uncertainty, and social imitation. Many financial economists recognize that positive feedbacks and in particular herding is a key factor that can push prices upward (downward) faster-than-exponentially which if unchecked can lead to bubbles.

Roughly 10 years ago Johansen and Sornette proposed model that attempts to incorporate those ingredients into a traditional rational expectations model of bubbles proposed by Blanchard.

The Jochansen-Sornette model assumes the financial market is composed of two types of investors: perfectly rational investors who have rational expectations and irrational traders who are prone to exhibit herding behavior. The noise traders drive the crash hazard rate according to their collective herding behavior, leading its critical behavior. Due to the no-arbitrage condition, this is translated into a price dynamics exhibiting super-exponential acceleration, with possible additional so-called “log-periodic” oscillations associated with a hierarchical organization and dynamics of noise traders.

A+B*(t-tc)^C*(1+D*COS(w*LN(t-tc)+O)

This so-called log-periodic power law (LPPL) dynamics given by has been previously proposed in different forms in various papers. The power law A−B(t−tc)_ expresses the super-exponential acceleration of prices due to positive feedback mechanisms. The term proportional to cos(w ln(t-tc)+o) describes a correction to this super-exponential behavior, which has the symmetry of discrete scale invariance. This formulation results from analogies with critical phase transitions (or bifurcations) occurring in complex adaptive systems with many interacting agents. The key insight is that spontaneous patterns of organization between investors emerge from repetitive interactions at the micro-level, possibly catalyzed by top-down feedbacks provided for instance by the media and macro-economic readings, which are translated into observable bubble regimes and crashes.

In previous posts I fit the LPPL formula into several financial time series. This time I fit LPPL into EUR/PLN exchange rate. As it is seen on the chart the formula fits remarkably well into the data. Even more surprisingly the LPPL model explains not only the periods when the positive feedbacks let to the zloty overvaluation but also it fits well to the period when zloty was depreciating (2001-2003). This confirms the universality of the process described by LPPL formula which describes well not only bubbles but also antibubbles.

Read More......

the global fiscal outlook is somber

IMF has released a Staff position note: Fiscal implications of the global economic crisis. Conclusion of the note is simple the global fiscal outlook is somber. Present fiscal cost of the crises + aging populations in advanced economies will strongly contribute to increase in DEBT/GDP ratios in the future. Also this momentum may raise the question of fiscal solvency. What is then the next big thing?
a) rising inflation
b) fiscal insolvency
c) a+b
or c) (put here something optimistic)

Read More......

Risk appetite remains low

Surprisingly the net average positioning index remains almost flat despite recent rally. (The shot description of the index you may find in one of the previous posts). It may indicate that portfolios still remain underweighted. So it looks like this rally has still room to go

Read More......

Polish language version of the bubble hunter

I just created Polish language version of the bubble hunter link here. “Łowca Baniek” blog will be rather focus on the Eastern Europe, bubble hunter will remain my main conceptual notepad

Read More......

Reflexivity and Eastern Europe (or can Ukraine be a Lehman Brothers of Eastern Europe?)

I was expecting this article to come sooner or later but when I read it this morning in FT I cannot say that I’m happy because for the time being I’m still living in Eastern Europe.

Not so long ago the consensus about Eastern Europe economies was that they are FUNDAMENTALY sound and those economies should decouple from global slowdown. At that time I wrote that this is not sustainable process and that the decoupling will be followed by the recouping to the rest of the world . Now after the first wave of debt/currency crises went through the Eastern Europe the consensus story has been changed somehow into more doom and gloom story. But now some say that Eastern Europe is almost FUNDAMENTALY cheep (i.e. here)
I think this way of thinking is FUNDAMENTALY wrong as markets are not efficient pricing machines Some/Most market participants believe that the markets tend toward equilibrium but equilibrium is just only first approximation how the market works.



My critique is not new. Milton Friedman said that idea of fully efficient market is inherently contradictory. In order to remove market inefficiencies we must have traders who are motivated to exploit them. But if the market is perfectly efficient there is no possibility to make excess profits. While efficiency might be true at first order, it cannot be true at second order: There must be on-going violations of efficiency that are sufficiency large to keep traders motivated. The misconception of efficient market is even obvious now than ever before, because it was the intervention of the authorities that prevented financial market from the total meltdown, not the market themselves. Indeed non-equilibrium nature of the markets is especially visible in the sharp price movements occurring at the booms and (especially) crashes which are accompanied with massive price jumps. Question is how in first place the market gets to “critical” point. The Eastern Europe decoupling story was based on the fact that economic growth in recent years was strongly based on domestic demand. Domestic demand was continuously stimulated by credit growth and budget deficits. At the beginning of the process the credit growth was limited and its impact on the price assets was limited. However lending usually stimulates economy. A strong economy tends to enhance the asset values, increases country creditworthiness and also often tigers local currency appreciation. As the asset prices grows the banks are more willing to lend because (i.e.) the value of the collaterals is growing the more credit is available the stronger economy grows. This positive feedback process continues until a point is reached where credit cannot grow fast enough to stimulate economy. By that time the asset value strongly depends on the credit growth and as the credit growth fails to accelerate further the asset values starts to decline. At the “critical” point the process reverses. Declining prices of assets/collaterals decreases the banks willingness to lend which has depressing impact on economy. Since creditworthiness/collateral has been pretty fully utilized at that point, a decline may precipitate the liquidation of loans which in turn may make the decline more precipitous.

This is very, very simplified vision of the process which leads to asset bubbles. However one of the features of the process is that Economic FUNDAMENTALS ARE NOT EXOGENOUS to the process. Unfortunately is not my idea but George Soros reflexivity which he defines as a “two-way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them, but on their perception or interpretation of the situation. Their decisions make an impact on the situation and changes in the situation are liable to change their perceptions”
(Unfortunately Soros is not good at math but it’s easy to show that his reflexivity idea is a system of differential equations. More formal model definition and solution to the systems of “Reflexivity” differential equations you can find here in excellent V.I. Yukalov D.Sornete paper).

But let’s come back to the main subject and let’s try to find out what may come next. Financial linkages/Interlinkages in Eastern Europe are very tight. With the increase in the foreign ownership of the banking system in Eastern Europe the degree of financial interlinkages among Western Europe and Eastern Europe has also grown substantially i.e. Austria’s lending exposure to Eastern European countries top 80% of GDP ( IMF Paper with the statistics you can find here). As the economy slows the processes which lift asset prices is in full reverse as investors starts to withdraw the money. The liquidation of the loans takes time: the faster it has to be accomplished, the grater the effect on the value of the collateral . In the bust the reflective interaction of the loans between collateral becomes compressed within very short time of period the consequences can be catastrophic (reflexivity works both ways)

For several years Ukraine economy was flying on cheep credit and high steel prices now both engines has been lost which is not only the case of Ukraine but also for several countries in the region (i.e. Romania, Bulgaria). And now we are in self reinforcing process of loans liquidation which reinforces the drop of asset prices. Because of the size of Ukraine and close financial interlinkages acrros the Europe the comparison of Ukraine potential default to Lehman Brothers bankruptcy and its implications for the whole financial system makes sense for me

End of Part ONE

Read More......

Money has often been a cause of the delusion of multitude

“…Money has often been a cause of the delusion of multitude. Sovereign nations have all at once become desperate gamblers and risk almost their existence upon the turn of the piece of paper…””…Men it has been well said thinks in heards it will be seen that they go mad in herds while they only recover their senses slowly and one by one..”
The quotation comes from the book “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds” written by Charles MacKay in 1852. (The complete version of the book you can download here). In volume one of the book author describes the Mississippi scheme, the South-Sea Bubble, the tulipomania among others market bubbles and crashes from the past. After reading all that stories I had strange feeling that those stories aren’t quite different from those which I’m reading nowadays in the newspapers. A striking feature of the crisis (then and now) is that the situation evolved rapidly and appeared to be driven by emotion. Now word “FEAR” appears in almost every news or article covering present market/economic events. Over/(lack of)confidence, fear, gloom, doom, crowding aren’t concepts closely related to good old-fashioned rationality but are related to the out of equilibrium processes . In contrast to that modern economics is based on equilibrium models, which assume the rationality of the economic agents and put emphasis on the importance of expectations. Don’t get me wrong. I’m not calling to get rid of the equilibrium models from economics (because they are useful) but I think that the current crisis shows the limitations of the mainstream paradigm.
The source of the crises was originally precipitated by the levels of the credit that are difficult to justify as rational. I’m not talking here just about UK,US homeowners who got a large amounts of loans with no money down. I’m also talking about whole nations (i.e. Iceland, Hungary, Ukraine, South and Eastern European Countries, Baltic countries) which were flown with almost free credit assuming that those countries will grow only faster and faster and will be able to payback its debt in the future.
Is the crisis a simple consequence of madness of the crowds, completely orthogonal to the equilibrium model? I don’t think so but it’s obvious to me that lenders were way too optimistic in their assumptions and maturation of this systemic instability led the system to the critical zone and to an inevitable crash
This blog is about non-equilibrium processes and especially about power laws in economics. Power law distributions imply that rare events (like October crash) are occurring with a finite non-negligible probability in the complex systems. Is therefore meaningful to ask the following question: How is the dynamics of a complex system affected when system undergoes to extreme event? In other words in the following posts I will focus on the market dynamics after the large crises trying to answer the question how long will take the transition phase to bull market.

Read More......

This is bottom . SP will hit 1300 mark in December

In the post published on this blog earlier I was predicted that in October the market will test July lows. It is always difficult to precise estimate the “critical“ point when the market will turn but I feel that it may happen within next few days or even today. Here are my arguments:



1) Blogosphere is full of doom and gloom stories. Number of posts in blogs with some including the word ”crises” jump to 350

2) IMF is turning to more gloomy tone. Just 3 Months ago IMF revised up the GDP forecast for US and EUROPE but now in the latest WEO they suggest that US economy will tank

3) Politicians around the globe are not only calling for actions but they already advanced in legislative process (US). Even in Europe politicians woke up and will meet on EU mini summit this weekend. (politicians are always well behind the curve)

4) All my colleagues are bearish, Now most of CNBC ‘s guests predict recession

My general point is being that I feel like only optimist isle surrounded by ocean of pessimism and gloom. It sounds like classic contrarian argument which may sounds odd in the eve of US earnings season. But financial markets are far beyond supply and demand curves. This is very misleading picture of the market. It implies that the investors base their decisions on the fundamentals, whereas the goal of the market participants is to make money. Only if the market prices reflected the fundamentals accurately would it make sense for them to be guided by those fundamentals and in that case nobody could make money than anybody else – this is an absurd conclusion!

Long time ago John Keynes formulate his beauty contest thought. He was arguing that the stock prices are not only determined by “fundamental” factors but mostly how the crowd of investors will behave in the future. In Keynes’view, the optimal strategy is not to pick those faces the player thinks the prettiest, but those the other players are likely to think the average opinion will be, or those the other players will think the others will think the average opinion will be, or even further along this iterative loop. Beyond a certain point this self-validating feedback loops become unsustainable and market crash (this is valid for both boom and bust cycles) (This type of cooperative behavior may be bay be model well by Ising model )
We were in the negative feedback loop since the beginning of September and we are approaching the “critical” turning point. It obviously doesn’t mean that reality will change. Still the deep recession is ahead of us and but that’s different story. The end year rally is just ahead of us.

Read More......