THE pessimism that drives down stock prices spreads just like tiny cracks in a solid, say a pair of physicists. The idea has led them to a disheartening prediction for investors: the US market鈥檚 latest tentative recovery will last only a few months into next year, before it tumbles even further.
Didier Sornette and Wei-Xing Zhou at the University of California, Los Angeles, developed their stock market model while studying how materials fail under stress. They believe the feedback processes that determine how cracks worsen and eventually fail also govern the way information flows through the stock market and changes opinion.
Isolated microcracks that form in a material under stress can multiply to form a network of fractures that merge into deeper cracks. When the cracks reach a critical density they combine, causing catastrophic failure.
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Sornette pictures a stock trader who goes against the consensus as the equivalent of a microcrack. For example, a trader might predict that share prices will fall, while the market as a whole is optimistic. As investors and traders exchange opinions and information, the pessimistic viewpoint can spread and multiply, just as cracks do, until a critical number of market players are converted. Their pessimism then drives the share price down.
The physicists developed a mathematical model to describe such systems. When they applied it to the Standard & Poor鈥檚 500 index 鈥� which averages the stock value of 500 companies chosen to be representative of the US market 鈥� they identified a phenomenon they describe as an 鈥渁ntibubble鈥� (Quantitative Finance, vol 2, p 468).
A 鈥渂ubble鈥� occurs when optimism spreads, artificially inflating the market. The bubble may burst dramatically, but if it doesn鈥檛, it will be followed instead by a slow downward adjustment 鈥� an antibubble. Antibubbles have two key characteristics, Sornette has found: the market value slides downwards overall, and it oscillates as it does so.
The value of the S&P 500 has been riding an antibubble roller coaster since August 2000, says Sornette. He plugged into his model the rate of the downward trend and the frequency of the oscillations, then ran it forwards to 2004. He found that the 鈥渦p鈥� the US market is currently experiencing is merely a wobble, and predicts that hopes of a recovery will be dashed by mid-2003, as the market sinks into a trough that may be even deeper than this year鈥檚 low.
Neil Shephard, an economist at the University of Oxford, is sceptical. 鈥淓conomic theory says it shouldn鈥檛 work,鈥� he says. Traders act on all available information about the market when buying or selling shares, he points out, so the prediction will itself affect the outcome.
But Sornette counters that traders often ignore predictions, and says their actions are 鈥渞ooted in fear and greed鈥�. The ideals of economics don鈥檛 necessarily apply in such an imperfect world, he says. He also points out that he made successful predictions about the Nikkei index in 1999. 鈥淚 invest my own money and I am doing quite well,鈥� he told New 杏吧原创.