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Bubbles for Fama from Sornette

Author

Listed:
  • Dongshuai Zhao, CFA

    (ETH Zürich - Department of Management, Technology, and Economics (D-MTEC))

  • Didier Sornette

    (ETH Zürich - Department of Management, Technology, and Economics (D-MTEC); Swiss Finance Institute; Southern University of Science and Technology; Tokyo Institute of Technology)

Abstract
Galvanized by the claims of Greenwood et al. in Bubbles for Fama that “a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward”, and Fama’s quote (June, 2016) that “Statistically, people have not come up with ways of identifying bubbles”, we present significant evidence to the contrary of both statements. Using a methodology called logperiodic power law singularity (LPPLS), which has been developed by the Sornette group over more than two decades, we show that a LPPLS-based “bubble confidence indicator” allows one to diagnose ex-ante the presence of a bubble. Using superposed epoch analysis, we find an excellent timing performance of price regime shifts, and more so, the larger the bubble confidence indicator. Moreover, we identify two classes of regime shifts following an accelerated price growth qualified by LPPLS: (i) bubbles followed by a large drawdown or crash, and (ii) price catch-up followed by a plateau, associated with the convergence to a stable price level. Indiscriminately mixing these two types of accelerated transient price increases may explain in part previous failures to diagnose bubbles and their aftermath. While the existence of the first class of transient accelerated price increases followed by crashes is a long-standing puzzle, the existence of the second class of transient accelerated price increases followed by a plateau poses a challenge to the efficient market hypothesis, thus constituting a new puzzle: the convergence to a stable price level, while accelerating, is slow, with investors and the market taking weeks to months to digest available information and to progressively converge to the final higher valuation consensus.

Suggested Citation

  • Dongshuai Zhao, CFA & Didier Sornette, 2021. "Bubbles for Fama from Sornette," Swiss Finance Institute Research Paper Series 21-94, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2194
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    File URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3995526
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    Cited by:

    1. Yang, Hui & Ferrer, Román, 2023. "Explosive behavior in the Chinese stock market: A sectoral analysis," Pacific-Basin Finance Journal, Elsevier, vol. 81(C).

    More about this item

    Keywords

    financial bubbles; superposed epoch analysis; log-periodic power law singularity; confidence indicator; crash; drawdown; precursors; super-exponential;
    All these keywords.

    JEL classification:

    • C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General
    • C40 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • G01 - Financial Economics - - General - - - Financial Crises
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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