We Are Warned – Precisions About the Log-Periodicity Power Law Singularity Model
Last week, I published an article about the log-periodicity power law singularity (LPPLS) model which suggests a theoretical but significant correction of the Nasdaq by the end of the summer. Many people are skeptical about the model and/or the conclusion, so I am happy to respond to some critics.
“Finance Is Not Physics”
First, people cited Austrian economics, arguing that economic value is a pure human concept that cannot be explained by other sciences and that cannot be translated into robust equations. I used to think like that too, and I still believe that Austrian economics are worth it. But once again, there are too many similarities between capital markets and natural phenomena like seismic activity, solar flares, or epidemics, so we should not ignore them.
Second, it is true that mathematics has been misused in the past, but you should blame the models and their authors for that, not the tools. Financial mathematics can be held responsible for the financial crisis of 2007-2008, but mainly because people made questionable assumptions about how markets are supposed to work, building beautiful but meaningless theories on top of that. Contrary to economists, physicists aim to build theories that would fit with real life, even if the task is more complex and more frustrating.
Last but not least, physics research was not the only scientific reference in my post, since the concept of market narrative mainly derives from an anthropological perspective. As Per Bak said, interdisciplinarity may be the right approach to solve the problem of nature complexity. And that includes financial markets.
“The Fed Will Save Us”
Once again, the main argument advanced in my previous post is the fact that equity markets are mainly driven by the “Fed put” narrative. Many investors do not believe that a crash is possible, citing the Fed and TINA as key reasons for that, and this is in fact just confirmation of my thinking.
The relation between central banks and asset valuation is mainly intersubjective. Most people believe that quantitative easing is positive for stocks, but such a human belief should not be confused with a natural law. Of course, the equation of exchange tells us that an increase in money supply can lead to more transactions and higher prices, but this only occurs if agents are willing to buy. Thus, agents’ psychology might play a more important role than QE or NIRP.
Still not convinced? Think of the old Mississippi Company which led to the one of the biggest speculative bubbles in modern history. When the shares of this company crashed, Banque de France and its governor John Law decided to intervene doing a so-called “equity QE”. What could wrong if a central bank starts to buy stocks? Well, it did not stop the crash. The Kingdom of France was ruined, and one consequence of that was the French Revolution a few decades later.
Past Bubbles and the LPPLS Model
Even if all this remains theoretical, it is interesting to look at recent and spectacular booms and busts that were correctly predicted by the LPPLS model:
Bitcoin mania (2017) – If you run the model from January 1st to December 15th 2017, then it tells you that a crash was imminent. And guess what, bitcoin started to drop three days later.
China A shares (2015) – It is ironical to mention this bubble as Shanghai Composite index was +6% up this morning due to retail investors frenzy. The model was run from June 30th 2014 to June 1st 2015. The crash came a bit earlier than the prediction, but the outcome remains unchanged.
Party Like It’s 1999
Whether the LPPLS model is right or not, warning signals have accumulated for months. Who needs a model to detect a bubble when US market cap to GDP ratio is above 150% and Shiller PE ratio is above 30? Who needs a model when you know that earnings recession started in 2019? Who needs a model when the world has just been hit by one of the most violent economic shocks in History?
Stimulus and monetary policy will not be sufficient to justify current valuations, especially when it comes to US technology stocks.
Nevertheless, everyone still has the right to believe that “this time is different”.