Bubbles and Crashes

Abstract

Episodes of market crashes have fascinated economists for centuries. Although many academics, practitioners and policy makers have studied questions related to collapsing asset price bubbles, there is little consensus yet about their causes and effects. This review and essay evaluates some of the hypotheses offered to explain the market crashes that often follow asset price bubbles. Starting from historical accounts and syntheses of past bubbles and crashes, we put the problem in perspective with respect to the development of the efficient market hypothesis. We then present the models based on heterogeneous agents and the limits to arbitrage that prevent rational agents from bursting bubbles before they inflate. Then, we explore another set of explanations of why rational traders would be led to actually profit from and surf on bubbles, by anticipating the behavior of noise traders or by realizing the difficulties in synchronizing their actions. We then end by discussing a complex system approach of social imitation leading to collective market regimes like herding and the phenomenon of bifurcation (or phase transition) that rationalize what crash can occur in unstable market regimes. The key insight is that diagnosing bubbles may be feasible when taking into account the positive feedback mechanisms that give rise to transient "super-exponential" price growth, the bubbles.

Dragon-Kings, Black Swans and the Prediction of Crises

“…Most approaches to explain crashes search for possible mechanisms or effects that operate at very short time scales (hours, days or weeks at most). Other researchers have suggested market crashes may have endogenous origins (see Kaizoji and Sornette [62] and references therein).…”

Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles

“…So, we are not claiming a direct causality here, just that the Brazilian stock market had entered a fragile period, a "critical regime" (Sornette, 2017;Kaizoji and Sornette, 2010;Sornette and Cauwels, 2015), that made it more vulnerable then usual to external shocks. Figure 46 shows the bubble in the BOVESPA index, fuelling a 130% price appreciation in the year before the crash.…”

Predicting Financial Market Crashes Using Ghost Singularities

“…During financial bubbles, positive feedback mechanisms give rise to the so-called super-exponential acceleration of prices [17][18][19][20], followed by the burst of the bubble in large drawdowns [21][22][23], i.e. crashes.…”