Forecasting Earthquakes, Geophysical and Financial

June 18, 2013

Growing up in the Midwest, my litany of childhood fears were limited. Typical of most red-blooded Midwestern boys. Tornadoes. Nuclear holocaust. School bullies. Steve Garvey with a full count. And cafeteria food.
Childhood on the west coast? Different story. Earthquakes, and their sudden and violent propensity to wreak havoc? Likely rank somewhere between bully and Garvey.
One imagines the childhood dread. The sudden, violent shaking of the earth below. Buildings quivering like tissue paper. Growing up, certain of the occasional earthquake? I would have been in diapers till high school.
Typically caused by the rupture of geological fault lines, earthquakes represent the sudden release of energy in the earth's crust. The product of seismic waves emanating outwards.
Tectonic shifts can happen anywhere that competing sides of a fault plane rub against, into or across each other. The longer and wider the fault line, the larger the magnitude. The higher the magnitude, the greater the destruction.
Thanks to geography, I do not fear earthquakes of the geological variety. But those of the financial variety? Like a meat pie on a dirty tray in elementary school. Very alarming.
2008 was the financial equivalent of a magnitude 10 earthquake. Unstable fault lines collapsed into each other. The energy released sent seismic waves reverberating across the globe. The infrastructure built along the fault lines was destroyed. Housing. Lehman Brothers. Bear Stearns. Merrill Lynch. Countrywide. Regional and community banks. Consumers. Spending. Employment. So much wealth.
How can we possibly fortify ourselves against such unforeseen events? According to Didier Sornette, we may soon be able to predict both earthquakes and financial catastrophes.
Professor Didier Sornette, a former UCLA geophysicist cum risk economist, has adapted the principles of earthquake science to the financial markets. Specifically, he specializes in forecasting extreme events in complex systems.
His work is compelling.
A professor at the Swiss Finance Institute as well as the Swiss Federal Institute of Technology, Sornette is associated with both the departments of Physics and Earth Sciences.
Check out Professor Sornette's excellent TEDGlobal 2013 presentation here.
Sornette's early work focused on a means for predicting earthquakes. Recently, he has used similar strategies to predict markets. Endeavoring to prove that investors react to the release of energy in financial markets in the same way that rock reacts to the release of energy from the earth's crust.
Utilizing his grasp of complexity theory and "out-of-equilibrium dynamics," Sornette seeks relationships between the component parts of complex systems. Given a specific situation, how does A affect C, and how does D respond?
Regarding complex systems, the whole is vastly more important than the sum of its parts. These systems exist in a level of complexity well beyond scientist's predictive capabilities.
In 2007, algorithms and advanced analytical tools did nothing to foresee the financial tsunami bearing down upon us. Even those on Lehman Brother's vaunted bond trading floor were comfortably unaware. Until they were drowning.
Sornette, however, believes that complex systems exhibit rare and sudden transition points - indicators, if you will - that belie (to discerning eyes) the extreme events ahead.
Yet, as earthquakes go, we can forecast. Recognize likelihoods. Fortify our homes, bridges and office buildings. Still, we cannot prevent them. Nor the consequences.
When stock market bubbles develop, investors respond in kind, time and again. The same herding patterns. Fear and denial give way to acceptance and greed. The initial tremors cause everyone to look up. Nobody expects the level of seismic energy to come, wave after wave, as investors seek to get stabilize themselves. To stay upright. Eventually, survival mode kicks in. Investors exit the building, after its already fallen. Poor decisions made at the worst possible time.
And this situation will repeat itself, time and again. Investing is equal parts math, psychology and history. The average investor, however, has little tolerance for this triumvirate.
Sornette believes that large stock market crashes are the social analogs of his so-called "critical points." These indicators are studied feverishly by the statistical physics community in relation to magnetism, melting, and other transformational phases of solids, liquids and gas. In other words, a stock market crash occurs because the market has entered an unstable phase. Any small disturbance can trigger that critical point, the instability required to catalyze the next transitional event. The point where equilibrium erodes. And chaos ensues.
Once triggered, the consequences of such a massive energy release within complex systems are similar. Earthquakes, volcanoes and stock markets.
Sornette's work provides a better understanding of the average investor's psyche as it continues to react to the massive energy release emanating from the 2008 credit crisis.
Similar to earthquakes, after which tremors and aftershocks continue near the fault lines, so do markets recoil in the aftermath of the credit crisis. Small tremors occur. Everyone runs for the exits. Of both buildings and markets.
Those experiencing earthquakes can suffer from post-traumatic stress disorders. Likewise, investors suffered through massive capital destruction in 2008. And now suffer from post-traumatic stress.
Investors consistently confirm this belief, recoiling in horror every time the market falls. Negative headlines persist. Volatility increases.
So, even as the recovery enters its fifth year, investors continue clinging to the exits. Running for cover under the proverbial doorframe, waiting for the earth to quiver and confirm their fears.
Like a real-life version of the Chicken Little fable, scared investors amass, affirming and stoking each other's fears, until a traumatic conclusion becomes inevitable.
Those who experience trauma often refuse to return to circumstances associated with the trauma. An office or apartment building. A mode of transportation. A bridge. Or a crowded urban area.
In similar fashion, many investors continue, even today, to shun equities. Choosing to remain in cash and bonds, even as market gains pile up. Even as the inflation-adjusted valuation of today's indices rest well below where they might be otherwise.
Will these vicious cycles continue, ad infinitum, until we figure out a way to detect these crises and so avoid them? Or, must our psyches evolve such that we respond to crisis differently?
I am doubtful of our ability to accomplish either. Consider the Chinese concept of Yin and Yang. Quite simply stated, it is only because of the risk that one achieves a reward. That interconnectedness of opposites throughout our lives is not only necessary, but desirable.
Sornette, however, believes that human beings may eventually be able to forecast such events. Earthquakes. Volcanoes. Tornadoes. Financial meltdowns. We could then develop effective countermeasures. Or steer away from the tumult.
Perhaps the answer is more simple.
We have long believed that individuals can train themselves to avoid the positive reinforcement mechanisms that accompany collective, herd-like behavior. By standing aside the mainstream, one is able to make a more objective, analytical assessment of any situation. And act accordingly.
Care to avoid an earthquake? Move away from the fault line.
So we exert investors to defer to methodology. Remain nimble. Avoid buy and hold, as well as advisors who wish to do so with your capital. Set trailing stops. And avoid the herd, especially in the instance of speculative manias.
Remember: once everyone is in, the party's over.
Which brings me back to Chicken Little, who forecast the end of the world. He quickly told his friends, who panicked and ran to tell the king. Finally, they come upon Foxey Loxey, who recognized the herd behavior before him. And appreciated the value of a good meal.
Sornette's optimism and idealism are commendable. His work may be groundbreaking. I have found, however, that the road to utopia is usually longer and more treacherous than anyone can forecast.

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