Chaos Researchers Say They Can Predict Market Bubbles
    By News Staff | October 20th 2013 10:30 AM | 14 comments | Print | E-mail | Track Comments

    Some of the more recent dramatic disasters in world-wide markets have occurred, not because people panicked or an election did not go someone's way, but because financial institutions have taken to hiring physicists who wrote papers on predicting chaos.

    If non-linear is just linear in really small steps, then predicting and controlling nonlinearity is manageable. But those extreme chaotic events, the "dragon kings", have not obeyed numerical models yet.

    An upcoming paper in Physical Review Letters seeks to tame that savage chaotic breast again, with a simple model of chaos predicting that it is possible not only to predict an extreme event, like a stock market collapse, but to intervene and prevent it from happening.

    Didier Sornette of the Swiss Federal Institute of Technology, director of the Financial Crisis Observatory, coined the term "dragon king.

    Dragon kings are less random than thought, the researchers say and in true nonlinear-is-just-linear-in-small-steps, find they can be anticipated and controlled.

    The latest finding is an outgrowth of experimental work 
    co-author Dan Gauthier, the Robert C. Richardson professor of physics at Duke University
    has been doing since the 1990s with simple electrical circuits he calls "chaos generators." Two identical circuits consisting of two capacitors, an inductor, a nonlinear diode and a power source, are each set to generate chaotic oscillations in their voltages and currents.

    Being identical, the credit-card sized circuit boards are supposed to oscillate in synch with each other when they are coupled - called "synchronized chaos." But in practice, they experience subtle variations in behavior so that the voltages and currents in one circuit do not match their twin.

    Because the behavior of each circuit is chaotic, the voltages and current change in an erratic manner over time, but both circuits are synchronized, so that they both change together and show the same behavior most of the time, Gauthier said.

    During a long run of the experiment, the data reveal that the chaotic behavior visits "hot spots" in which an extreme event, "a bubble," might occur. This is an event in which the circuits suddenly and temporarily loose synchronicity. Sometimes the size of the event is small, like a small change in a financial market, and other times it is gigantic, like a market crash. And the size of most of these disturbances follows a power law distribution, in which one variable changes as a power of the other. The most extreme events, the "dragon kings," are responsible for significant deviations from the curve of the power law.  

    Extreme events that may be governed by these laws would include sudden population crashes in species or freak waves in the ocean, Gauthier said. Other examples might be epileptic storms of activity in the brain and rolling power outages caused by an initial small disturbance, like a squirrel shorting out one substation on a large grid. Other examples could be found in the occurrence of incipient failure of materials and of engineering structures, in the synchronized behavior of kidney and heart cells in the body, in meteorological front dynamics and in climate change, among many others.

    In a series of experiments performed with the coupled chaos circuits by co-author Hugo Cavalcante of the Federal University of Paraiba in Brazil, it was found that the introduction of a tiny amount of current injected into one of the circuits at just the right time prevented a predicted dragon king from happening. "Maybe tiny nudges can make a big difference," Gauthier said. 

    "The limitation of our paper is that we haven't shown that our circuit has relevance to the stock market," which has many more variables, Gauthier said. "We aren't yet sure where to look, but for this one simple system, we figured out how to find it."


    I'm not sure if I want to laugh, or move to the desert and become a prepper.

    This is all very typical chaos stuff, a small push in the right place can guide a much larger system, it's deciding when and where to make that small push, and while the right push can make things better, the wrong push can make it worse, let alone people who are interested in shorting the market.

    But, let's not take my word for it, let discuss the dot com bubble. The stock market over heated, in part because of all of the internet startup's were going nuts during their IPO, some where worth it, a lot weren't. Investors, and then the public, kept seeing millionaires getting made over night, and it was hard to stay out of that kind of game. But the markets are all about confidence.

    Greenspan, wanted to dampen the market, it was getting to hot. So he started raising interest rates, push. The odd thing was that startup's don't borrow money from lenders, but get venture capital. This put pressure not on IPO's, but existing businesses. Then the bad news stated coming, Global Crossing push, Worldcomm push, Enron push. Investors started loosing money, the DOJ got involved with a bunch of jealous competitors ganging up on Microsoft, big push, can't count votes for a presidential election, big push. By then we were in a recession, and the market was off by 50-75%.

    The housing bubble started back during Clinton by forcing banks to loan money or get sued push, it just took a decade to inflate. It would have been easy to stop in the 90's, but the Gov decided everyone deserved to own a house, push.

    So, who decides what to push, and what not to push?

    Never is a long time.
    As the authors said, "The limitation of our paper is that we haven't shown that our circuit has relevance to the stock market".
    Relevance can only be determined after a proper model for market behavior exists. Present models are accurate only when describing past events and their predictions are notoriously inaccurate.
    Luiz S
    So basically this tells us nothing we didn't already know.
    And even when we do identify a bubble, it gives us no insight into what we need to do.
    Never is a long time.
    It tell us that, for the chaotic model created by their circuit, tiny interventions may prevent huge oscillations. The rest are conjectures.
    Luiz S
    First, I'm gonna nitpick on spelling: "...tame that savage chaotic breast..." I'm pretty sure that this is supposed to say "beast," lol!

    Second, as a trader, I know full well what can transpire in the market if there is a broad-based prediction of an upcoming bubble. Such knowledge will cause people like me to dump our stocks (assuming a stock bubble, for example) or, for the more bold, to short those stocks. There are always going to be people that want to make money off of others' suffering. This is natural, albeit disturbing to many. This leads to the conclusion that such knowledge should be retained by a government organization or oversight committees. However, since those are corruptible, then we're not necessarily better off. So what can truly be done about these bubbles? I think there should be a system in place whereby a transparent group of individuals (mostly comprised of scientists, like physicists, mathematicians, statisticians) make the decision to freeze selective markets or make broad pre-crash financial decisions. Would this ever occur? Very unlikely. Those in power are reluctant to relinquish their power. So are we doomed to repeat past mistakes and endure crash after crash? I believe the answer to that is simple: absolutely. Until a new world order is established (one where scientists are in charge of everything, ideally), we must slog through our existence without surety of the future.

    No, it's breast and always has been. 
    The wisdom of crowds is far, far better than any "transparent group of individuals (mostly comprised of scientists, like physicists, mathematicians, statisticians)" could ever be, and such a group is just as likely to wield their power to their own advantage as any other group of likely individuals would. Just look at how the greens and activists took over climatology, and that doesn't involve the bending of markets. Although Al Gore has made hundreds of millions off carbon, at the same time as he's flying the globe warning of climate Armageddon.

    And if you're a trader, you didn't realize we were in a stock bubble in 1998-2000-2001 , and a housing bubble in 2004-2007 time frame? It was obvious, and you can't close the markets down for years.

    Lastly the dot com bubble burst when the public lost confidence in the economy and markets and started to selling on bad news, unfortunately the bad news just kept coming, and as I mentioned Greenspan put tension in the market by raising interest rates, Pop!
    Never is a long time.
    I have to disagree with you that the wisdom of the crowds is far better than a small group of scientists. For one, crowds are easily swayed with charisma and rhetoric, neither of which has anything of substance to offer toward a solution. For another, the average intelligence of the people in general is lower than the average intelligence of a scientist. Lastly, scientists are less corruptible, but that point is just my opinion, as a scientist (physicist) myself with many other friends who are scientists. As for corruption of science in general, I'm not saying it doesn't happen. But climate change is an issue that needs to be addressed before it gets much worse.

    As for those bubbles, or any long-period disruption, I did not mean to imply that the markets should be frozen for years. I just put that forth as one option. The other option (broad-based financial decision) was worded vaguely on purpose to be an all-encompassing choice.

    My ultimate point is that these crashes and other financial disasters are, for all intents and purposes, un-preventable.

    I agree that in most truly creative endeavors the wisdom of crowds is not superior. A crowd would not have come up with the theory of gravity, much less the calculus to prove it. But on simpler things it is more accurate - the mean of 500 people guessing beans in a jar will be more accurate than Newton every single time.

    Because financial markets are creative, I doubt they are preventable either. By introducing a few rational players with unreasonable control, the game gets simpler - you just learn the mind of the players.
    For one, crowds are easily swayed with charisma and rhetoric
    This I agree with!
    scientists are less corruptible
    This I'm not so sure of. I'm not implying that you or your friends are corruptible, but there are some very public cases of scientific malfeasance, with climate science being pretty close to that state. I think Dr Curry has a very appropriate quote on this:
    In terms of actual scientific facts in climate science, we have the infrared emission spectra of CO2. The rest of what passes for ‘information’ in the parlance of Lewandowsky, Mann etc. is really hypotheses or theories.
    Never is a long time.
    There are public cases of scientific malfeasance, but they are minority occurrences. I understand the media preoccupation with such cases, but they happen less often than the media would have you believe. As for evidence of climate change, we have: CO2 and other greenhouse gas increases, ice core comparisons between now and any time in the last few million years (but they show evidence even over the last few decades), sea level rise, global temperature rise, warming oceans, shrinking ice sheets, declining arctic sea ice, glacial retreat/disappearance, and ocean acidification. These are the facts; how they affect us are the hypotheses or theories.

    But I do believe we are digressing off the original topic. The point is the next bubble is always growing right in front of us and we won't collectively see it until it pops.

    Please see additional comments below:

    But your evidence isn't conclusive as to whether this last warming was unique, nor did it conclusively prove it was caused by Co2. There are lots of theories and hypotheses that this is the case, but it isn't proof, and surely there isn't cause to drastically impact the worlds society.

    I'd love to see those worried about warming protest for building more nuclear power plants.

    If you'd like to continues this, go here.(I'm working on opening it for comments)
    Never is a long time.
    ...the next bubble is always growing right in front of us and we won't collectively see it until it pops.

    Yes, until a decent model for financial markets behavior is developed.
    We know that bubbles happen, so the model should include them, as well as other unpopular features such as inactive periods or discontinuities (absence of liquidity, time intervals where no transaction happens) and price jumps (bubbles and crashes).

    The creation of such predictive model may or may not be possible but, if possible, it will not happen while economists and market professionals remain in denial of the observed facts: they collectively insist on calling the bubbles, crashes and liquidity squeezes "exceptions" so they can try to describe or simulate market behavior using functions and statistics.

    We know for a fact that prices may jump up and down from one transaction to the other and that liquidity is an exception, not the rule (time lapses between transactions are actually quite common). Also, since the number of transactions in most markets is often far from infinite, most markets fail to comply with this essential premise for the application of statistic formulas. It is hardly a surprise that the next bubble is always growing right in front of us and we won't collectively see it until it pops.

    In fact, the use of inadequate models is a possible cause of bubbles and crashes. At the least, it makes them worse.

    Luiz S
    I hope Jon G follows this as it applies to his last post as well.

    I disagree on not seeing the bubbles develop(maybe the key word is collectively), I had conversations with my Mom in 1999 and 2000 that the market had increased beyond reasonable expectations of the "fundamentals", there were articles on it, even Greenspan talked about it, the difficult part is when to buy into the market, and when to sell. It's easy to see the market going up, and wanting to capture some of that, either by buying in or not selling what you have.

    I worked for one of the IPO's late in 1999, but it was my 3rd IPO, and I knew too much lore of paper millionaires who ended up with worthless paper, and as soon as I could I sold all of my vested shares, I did okay but between taxes and the bubble I ended up with about 25% of what it was worth in Jan 2000. But I knew it was going to end, just didn't know when nor did I expect things to be as bad as they were (9/11 and gulf war II).

    And to get back to topic, this paper is worthless for any of this that matters.
    Never is a long time.