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Diagnosis and Prediction of Market Rebounds in Financial Markets

42 Pages Posted: 14 Apr 2010  

Wanfeng Yan

ETH Zurich

Ryan Woodard

ETH Zurich

Didier Sornette

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

Date Written: March 29, 2010

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.

Keywords: negative bubble, rebound, positive feedback, pattern recognition, trading strategy, error diagram, prediction

JEL Classification: C53, G01, C45

Suggested Citation

Yan, Wanfeng and Woodard, Ryan and Sornette, Didier, Diagnosis and Prediction of Market Rebounds in Financial Markets (March 29, 2010). Swiss Finance Institute Research Paper No. 10-15. Available at SSRN: https://ssrn.com/abstract=1586742 or http://dx.doi.org/10.2139/ssrn.1586742

Wanfeng Yan

ETH Zurich ( email )

ETH-Zentrum KPL
Kreuzplatz 5
Zurich, CH-8032
Switzerland

Ryan Woodard

ETH Zurich ( email )

Department of Management, Technology and Economics
Kreuzplatz 5
8032 Zurich, CH-1015
Switzerland
+41 44 632 83 79 (Phone)
+41 44 632 19 14 (Fax)

HOME PAGE: http://www.er.ethz.ch/

Didier Sornette (Contact Author)

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

Scheuchzerstrasse 7
Zurich, ZURICH CH-8092
Switzerland
41446328917 (Phone)
41446321914 (Fax)

HOME PAGE: http://www.er.ethz.ch/

Swiss Finance Institute ( email )

c/o University of Geneve
40, Bd du Pont-d'Arve
1211 Geneva, CH-6900
Switzerland

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