By crash pattern I’m referring to Didier Sornette’s Log Periodic Power Law (LPPL). This is a price trend that has exhibited super exponential price acceleration with log periodic oscillations and mean reverting residuals. This type of pattern does not always lead to a crash but has led to a change in regime in price action. I noticed the pattern forming visually and then John Hussman confirmed a fit to the model on his twitter feed last week. It is an interesting event to consider, although traders should always default to the price action at hand, as patterns and divergences can exist longer than we can remain solvent if we ignore the reality of price action.
A 1590; B -260; Tc 2013.272; beta = 0.55; C = 0.28; omega = 10.2; phi (phase) 2.3. Classic uncorrected, diagonal, high frequency ramp at end
Not convinced that markets obey math, but increasingly shallow corrections at accelerated frequency suggest euphoria
Geek’s Note – Log-periodic Sornette-type bubble in S&P 500 with Tc = 2013.27 just reached its finite-time singularity. Interesting to watch.
Sornette bubbles – increasing volatility at 10-minute intervals is indicative of log-periodic fluctuations => singularity: buying every dip
Source: John Hussman
This pattern got media coverage a couple years ago when it predicted a a drop in the Chinese equity market. I thought the following quote helped explain what the pattern is trying to model in terms of underlying agent dynamics.
Chinese Equity Bubble: Ready To Burst
Patterns emerging from complexity
Due to their very nature, financial markets exist of interacting players that are connected in a network structure. These inter acting players, often referred to as interacting agents, are continuously influencing each other. In scientific literature it is said that such a system is subject to non-linear dynamics. Modeling such a system in full detail is practically impossible to do. That is why the long-term behavior of the global economy or the weather is quite hard to predict.
Recent research, however, has provided new tools to analyze complex non-linear systems without having to go through the simulation of all underlying interactions. When interacting agents are playing in a hierarchical network structure very specific emerging patterns arise. Let us clarify this with an example3. After a concert the audience expresses its appreciation with applause. In the beginning, everybody is handclapping according to their own rhythm. The sound is like random noise. There is no imminence of collective behavior. This can be compared to financial markets operating in a steady-state where prices follow a random walk. All of a sudden something curious happens. All randomness disappears; the audience organizes itself in a synchronized regular beat, each pair of hands is clapping in unison. There is no master of ceremony at play. This collective behaviour emanates endogenously. It is a pattern arising from the underlying interactions. This can be compared to a crash. There is a steady build-up of tension in the system (like with an earthquake or a sand pile) and without any exogenous trigger a massive failure of the system occurs. There is no need for big news events for a crash to happen.
I don’t want to claim this pattern has magical powers in predicting the market but it interesting to watch. Is it nothing more than an acceleration in trend? Is this the same as a rising wedge formation?
In my experience, rising wedge formations have an equal tendency to break upwards or downwards, making the pattern equally bullish and bearish. However, that is in looking at individual stocks. In an index this level of exponential acceleration is unlikely. We shall we what happens….
Update: John Hussman wrote his weekly market commentary and provided some great quotes regarding the LPPL:
It’s important to begin this section clearly: I don’t believe that markets obey math. Markets are complex, adaptive, behavioral systems that reflect the combined behavior and feedback between an enormous number of participants. At the same time, I strongly believe that the results of those interactions often take on observable patterns, and part of the job of investors is to recognize and understand those patterns.
Another pattern that we’ve trained ourselves to identify, with some concern, is an emerging tendency toward increasingly immediate attempts by investors to buy every dip in the market. This tendency reflects a broadening consensus among investors that there is no direction other than up, and that any correction, however small, is a buying opportunity. As investors clamor to buy ever smaller dips at increasing frequency, the slope of the market’s advance becomes diagonal or parabolic. This is one of the warning signs of a bubble. It does not require much of a “catalyst” for these bubbles to burst, other than the retreat of some investors from the unanimous consensus that buying every dip is an act of genius.
Back in July 2008, I observed this dynamic in the parabolic ramp of oil prices, writing “Geek’s Rule o’ Thumb: When you have to fit a sixth-order polynomial to capture price history because exponential growth is too conservative, you’re probably close to a peak” (see The Outlook for Inflation and the Likelihood of $60 Oil).
Indeed, the closest way to describe the price dynamics of oil at the time was to think in terms of a “log-periodic bubble” as described by Didier Sornette. The essential feature here isn’t precision in the fit between the log-periodic wave and the actual price, but rather the tendency of prices to experience a series of increasingly frequent but shallower dips, ending in a nearly uncorrected upward ramp in which virtually every dip is purchased as soon as it emerges. Again, I don’t believe that markets follow math, and Sornette’s approach shouldn’t be taken as implying such precision. For my part, the key feature of log-periodic bubbles is the tendency toward those increasingly frequent and shallow corrections, as investors buy dips with accelerating urgency, ending in a diagonal or parabolic ramp that I’ve identified with the yellow oval. That uncorrected binge at the end of mature, overbought, overbullish advances is a hallmark of bubbles.
Source: Hussman Funds
John Hussman goes on to provide some great examples of the LPPL with charts. you should definitely check out his article.