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Diagnosis and Prediction of Market Rebounds in Financial Markets

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  • Wanfeng Yan
  • Ryan Woodard
  • Didier Sornette
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    Abstract

    We introduce the concept of "negative bubbles" as the mirror image of standard financial bubbles, in which positive feedback mechanisms may lead to transient accelerating price falls. To model these negative bubbles, we adapt the Johansen-Ledoit-Sornette (JLS) model of rational expectation bubbles with a hazard rate describing the collective buying pressure of noise traders. The price fall occurring during a transient negative bubble can be interpreted as an effective random downpayment that rational agents accept to pay in the hope of profiting from the expected occurrence of a possible rally. We validate the model by showing that it has significant predictive power in identifying the times of major market rebounds. This result is obtained by using a general pattern recognition method which combines the information obtained at multiple times from a dynamical calibration of the JLS model. Error diagrams, Bayesian inference and trading strategies suggest that one can extract genuine information and obtain real skill from the calibration of negative bubbles with the JLS model. We conclude that negative bubbles are in general predictably associated with large rebounds or rallies, which are the mirror images of the crashes terminating standard bubbles.

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    File URL: http://arxiv.org/pdf/1003.5926
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    Bibliographic Info

    Paper provided by arXiv.org in its series Papers with number 1003.5926.

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    Date of creation: Mar 2010
    Date of revision: Mar 2011
    Handle: RePEc:arx:papers:1003.5926

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    Web page: http://arxiv.org/

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    1. Refet Gurkaynak, 2005. "Econometric Tests of Asset Price Bubbles: Taking Stock," Finance, EconWPA 0504008, EconWPA.
    2. Ide, Kayo & Sornette, Didier, 2002. "Oscillatory finite-time singularities in finance, population and rupture," Physica A: Statistical Mechanics and its Applications, Elsevier, Elsevier, vol. 307(1), pages 63-106.
    3. Thomas Lux & D. Sornette, 1999. "On Rational Bubbles and Fat Tails," Papers cond-mat/9910141, arXiv.org.
    4. Didier Sornette & Ryan Woodard & Maxim Fedorovsky & Stefan Reimann & Hilary Woodard & Wei-Xing Zhou, 2009. "The Financial Bubble Experiment: advanced diagnostics and forecasts of bubble terminations," Papers 0911.0454, arXiv.org, revised May 2010.
    5. Anders Johansen & Didier Sornette, 1999. "Critical Crashes," Papers cond-mat/9901035, arXiv.org.
    6. Sornette, Didier & Johansen, Anders, 1997. "Large financial crashes," Physica A: Statistical Mechanics and its Applications, Elsevier, Elsevier, vol. 245(3), pages 411-422.
    7. Jiang, Zhi-Qiang & Zhou, Wei-Xing & Sornette, Didier & Woodard, Ryan & Bastiaensen, Ken & Cauwels, Peter, 2010. "Bubble diagnosis and prediction of the 2005-2007 and 2008-2009 Chinese stock market bubbles," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 74(3), pages 149-162, June.
    8. Graf v. Bothmer, Hans-Christian & Meister, Christian, 2003. "Predicting critical crashes? A new restriction for the free variables," Physica A: Statistical Mechanics and its Applications, Elsevier, Elsevier, vol. 320(C), pages 539-547.
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