World stock market: approaching trend reversal?

Another interesting implementation of LPPL model has been just published today. Stanislaw Drozdz and Pawel Oswiencimka in short paper predict that core stocks indexes will face significant correction. A quote:

Based on our ”finance-prediction-oriented” methodology which involves such elements as log-periodic self-similarity, the universal preferred scaling factor 2, and allows a phenomenon of the ”super-bubble” we analyze the 2009 world stock market (here represented by the S&P500, Hang Seng and WIG) development. We identify elements that indicate the third decade of September 2009 as a time limit for the present bull market phase which is thus to be followed by a significant correction

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Sugar bubble ready to burst

Over the past few weeks, sugar has been on such upward spiral, hitting a 28-year high. Growing demand in Brazil for sugar to be turned into ethanol, coupled with a sharp fall in Indian and Brazilian production, have both sent sugar prices sky high. Many think that the supply shortfall will extend through 2010. Then from fundamental perspective valuation current sugar valuation may be correct as the supply fall short behind the demand. But to speak of supply and demand as if they were determined by forces that are independent of the market participant’s expectations is quite misleading.

It’s true the situation is not so clear cut in case of commodities where supply is largely dependent on production and demand on consumption. But the price that determines the amounts produced and consumed is not necessarily the present price. On the contrary, the market participants are more likely to be guided by future prices, either as expressed in future markets or as anticipated by themselves. In either case it is inappropriate to speak of independently given supply and demand curves because both curves incorporate expectations about future prices.

Those expectations may become self-referential which will lead to the positive feedback process (the higher the price or the price return in the recent past, the higher will be the price growth in the future). Positive feedbacks, when unchecked, can produce runaways which beyond a certain point become unsustainable ending in crash. In short LPPL models developed by Sornette aims, at detecting the transient phases where positive feedbacks operating on some markets or asset classes create local unsustainable price run-ups. The result of the analysis is summarized bellow in figure 1.

I analyzed sugar#11 future time series between September 2007 and September 3 2009. The y axis is logarithmically scaled so that the exponential function would appear as a straight line. LPPL fit exhibit upward curvature which is clear evidence that the prices were growing “super-exponentially”. The projected crash dates are September 5-15 .It must be noted that a good fit of the model to the data series is not a 100% certainty for a crash, but it clearly points at a bubble formation.

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The Chinese Equity Bubble: Ready to Burst (NOW)

D. Sornette et all just published interesting working paper on possibility of Chinese equity bubble to burst. A quote from summary:

Amid the current financial crisis, there has been one equity index beating all others: the Shanghai Composite. Our analysis of this main Chinese equity index shows clear signatures of a bubble build up and we go on to predict its most likely crash date: July 17-27, 2009 (20%/80% quantile confidence interval).

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Larry Summers on EMH

In today’s Financial Times you can find an interesting interview with Larry Summers, director of the US president’s National Economic Council. A quote:

The chief intellectual casualty of the current crisis has been the “efficient markets” school – the theory, associated with such erstwhile laisser faire gurus as Alan Greenspan, that market participants are governed by rational expectations and markets are self-correcting. As an academic economist, Summers has studied the shortcomings of that approach but, working on Wall Street gave him, he says, a more visceral understanding of the “self-referential” character of markets: “Markets are concerned with the ultimate health of economies and the like but they’re equally or more concerned with what the likely judgments of other market participants in the short run are.”

I’m not quite sure whether Mr. Summers is aware that he is proposes to extend economists tool box with non-equilibrium models. Nevertheless it may indicate that non-equilibrium models are silently leaking into main stream of economics. Efficient Market Hypothesis (EMH)has been falsified many times but I hope that this time it will be replaced by hypothesis better explaining how the market works. I think that G.Soros Reflexivity idea or MIT Andrew Lo Adaptive Market Hypothesis are good candidates to replace EMH for good.

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Asset price misalignments and the role of money and credit

ECB just released working paper on the role of money and credit indicators for detecting asset prices misalignments. This is most likely the second ECB publication on early warning asset bubbles indicators this year. Conclusion are quite intuitive that monetary and credit developments may be very useful in predicting asset bubbles burst. I have no problem with that conclusion because positive feedback loop from credit to house prices and again to credit was behind surge of house prices (also in Eastern Europe). I think that that to reduce price to price feedback (to avoid superbubbles creation) central banks should be more focused on credit growth and also closely monitor interactions between collateral valuation (i.e. house prices) and banks willingness to lend.

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Poland then(30's) and now(00's)

This chart is from Barry Eichengreen and Kevin O’Rourke column comparing today’s global crises to the Great Depression. Although the general conclusion of the comparison is rather grim (i.e. no signs of green shoots in hard data) but Poland in that comparison is doing relatively well. The fall in the industrial output is relatively soft. What is than the receipt for success? I think Poland is weathering the storm so well (in relative terms) because of several factors : 1) Underdeveloped banking system 2) less leverage 3) smaller gaps /macro imbalances 4) regulations/constrains for domestic households to borrow in foreign currencies. Only if Poland would use good times (2005-2007) to reform state budged then it could be a clear winner of the crises

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S&P 500 - critical time

It is fair to say that the global economic system is one of the most complex systems known in the biosphere. Compared to physics, economics differs in the important fact that the basic constituents, or “particles”, are already quite complex: human beings. So macroeconomic knowledge is insufficient tool to predict market trends as not only hard data are important but also how human beings think about macroeconomic reality.

John Maynard Keynes made a famous observation that much of individual economic behavior is due to “animal spirits” rather than long-term rational calculus so beloved by economic theorists and fundamental analysts.

That’s why I don’t want here to discus macroeconomic picture (i.e most recent US job readings) because it’s rather trivial task as we are still in negative feedback process (i.e. banks continue to tighten credit standards –> less credit available means lower demand -> lower demand means higher unemployment -> higher unemployment undermines creditworthiness -> banks continue to tighten credit standards etc)

What I would like to focus here on fact that series generated by some complex systems (i.e. financial markets ) are characterized by periodic or nearly periodic behavior. In these cases, the dynamics can be characterized by scaling laws. Such dynamics are usually denoted as fractal or multifractal, depending on the question if they are characterized by one scaling exponent or by a multitude of scaling exponents. Sierpinski gasket is one fine example of fractal




Some times its necessary to conduct series of tests to find the scaling factor but in case of S&P 500 the self similar pattern is clear at the first glance.

I simply repeat the analysis which I done last year and I got very similar scaling factor 2.7. In words it may indicate that S&P 500 is around critical time and that in August we may test the March lows.

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