Why Stock Markets Crash: Critical Events in Complex Financial Systems

"Sornette is another hugely impressive and wide ranging intellect who has contributed to many different areas of physics and economics. The ideas in this book can be traced back to his work on Ariane 4 rockets for the European Space Agency. There was a problem with these rockets when certain pressure tanks would randomly explode and no one could predict when this was going to happen. He developed a theory for how to predict when the explosions would happen. His theory relied on this basic insight: that the explosions were occurring not because of some particularly large effect – it wasn’t that the tanks were being hit by something or gas inside them was applying a large force – rather they were exploding because the tanks themselves were evolving into a state that would make them particularly susceptible to small kinds of effects. This was an idea that Sornette developed in many different contexts. One of the areas it was most productive was, as you say, in trying to predict earthquakes. He suggested that the largest earthquakes weren’t caused by a single large outside effect, such as a large change in the centre of the earth; it was that in certain circumstances the rocks at the surface of the earth were much like the rocket pressure tanks, and evolved into a state where relatively small fractures would get amplified. Sornette then looked to see if the same ideas could be applied to stock markets. Under what circumstances, he asked, do the small ups and downs in stock markets get amplified into major crashes? He argued that the same sorts of considerations were at play in markets as in rocket pressure tanks and earthquakes. The basic idea is a kind of co-ordination – that small effects are going to be amplified when there are correlations between different kinds of investor behaviour. One thing we hear about in connection with finance is ‘group think’ – that it seems at times that entire markets will take certain sorts of assumptions, behave as if they are true and stop questioning them even though the evidence is questionable; there is this co-ordination of investor behaviour based on a belief that something is true. Sornette argues that it’s the analogue of that sort of co-ordination in pressure tanks, earthquakes and financial markets that leads to this amplification process. He develops a whole mathematical theory of how to identify when that sort of condition develops in a market and to using that to predict when an ordinary intraday change is going to potentially get amplified into a market crash or bubble. I think of it as the gold standard of what ideas from mathematics and physics can in principle do. He takes an incredibly difficult problem and applies an entirely novel way of thinking about it and offers concrete mathematical tools coming out of physics to bring that problem under control. I think what Sornette has shown is just how wide ranging methods can be and just how hard the problems that can be tackled are."