Title: Detection of crashes and rebounds in major equity markets

Authors: Wanfeng Yan; Reda Rebib; Ryan Woodard; Didier Sornette

Addresses: Department of Management, Technology and Economics, ETH Zurich, Kreuzplatz 5, CH-8032 Zurich, Switzerland. ' Department of Management, Technology and Economics, ETH Zurich, Kreuzplatz 5, CH-8032 Zurich, Switzerland. ' Department of Management, Technology and Economics, ETH Zurich, Kreuzplatz 5, CH-8032 Zurich, Switzerland. ' Department of Management, Technology and Economics, ETH Zurich, Kreuzplatz 5, CH-8032 Zurich, Switzerland; Swiss Finance Institute, c/o University of Geneva, 40 Blvd. Du Pont d'Arve, CH-1211 Geneva 4, Switzerland

Abstract: Financial markets are well known for their dramatic dynamics and consequences that affect much of the world's population. Consequently, much research has aimed at understanding, identifying and forecasting crashes and rebounds in financial markets. The Johansen-Ledoit-Sornette (JLS) model provides an operational framework to understand and diagnose financial bubbles from rational expectations and was recently extended to negative bubbles and rebounds. Using the JLS model, we develop an alarm index based on an advanced pattern recognition method with the aim of detecting bubbles and performing forecasts of market crashes and rebounds. Testing our methodology on ten major global equity markets, we show quantitatively that our developed alarm performs much better than chance in forecasting market crashes and rebounds. We use the derived signal to develop elementary trading strategies that produce statistically better performances than a simple buy-and-hold strategy.

Keywords: JLS model; financial bubbles; market crashes; market rebounds; log-periodic power law; LPPL; pattern recognition; alarm index; market crash prediction; market rebound prediction; error diagrams; trading strategy; equity markets; financial markets; forecasting.

DOI: 10.1504/IJPAM.2012.046909

International Journal of Portfolio Analysis and Management, 2012 Vol.1 No.1, pp.59 - 79

Published online: 23 Aug 2014 *