Mimicry among stocks can predict stock market crashes

Feb 15, 2011 by Lisa Zyga report
The co-movement of stocks during six recent years shows the fraction of trading days during the year (f) in which a certain percentage of stocks (k/N) go up. The chart on the right combines all of the years. Image credit: Dion Harmon, et al.

(PhysOrg.com) -- Since early October 2008, when the Dow Jones Industrial Average began its drop that reached a low point the following March, many questions have been raised - particularly about what caused the crash and if it could have been predicted and somehow prevented. Some possible answers involve market volatility, changes in regulations, bank failures, easy credit, or any combination of external influences and internal market dynamics. In a new study, research analysts have found another clue to stock market crashes: high levels of collective stock movements - or market mimicry - tend to precede crashes, which suggests that measuring the mimicry level of the market could provide significant advance warning of an impending stock market crash.

The researchers, Professor Yaneer Bar-Yam and others from the New England Complex Systems Institute (NECSI) have posted their study, “Predicting economic market crises using measures of collective panic,” at arXiv.org. Their results indicate that it is the internal structure of the market, rather than external news, that is primarily responsible for crashes.

As previous research has shown, investors can often benefit from using a trend-following strategy - that is, buying or selling a based on the recent performance of other stocks (which is not necessarily based on any fundamental value). is high when many stocks move up or down together, which provides a potential point of origin of self-induced market-wide panic.

The researchers constructed a model of this mimicry to obtain co-movement data, which is the percentage of stocks that move in the same direction. When 50% of stocks move in the same direction (and 50% in the opposite direction), then there is no co-movement. But when substantially more than half of the stocks move in the same direction, this co-movement indicates higher levels of mimicry.

Using data from the past several years, the researchers plotted the number of days in a year that a certain percentage of the market moves up. For the year 2000, the curve showed that about 50% of stocks were moving together on any given day. But as the decade went on, the curve became flatter and peaked lower, indicating an increase in co-movement. By 2008, the curve was nearly flat, with its distribution reaching the critical value of 1. During this time, the likelihood of any percentage of stocks moving up was almost the same. As the researchers explained, when mimicry gets this high, external influences become very weak compared to the influences among stocks as a whole.

In addition, the researchers found that the Dow Jones’ eight largest drops (percentage-wise) during the past 26 years occurred during periods in which mimicry reached a level that was twice the standard deviation from the previous year. This signature increase in mimicry occurred before the drops by less than a year, indicating that crashes are preceded by nervousness that causes investors to demonstrate increasingly collective behavior. For this reason, the simple signature pattern could provide advance warning of an impending crash.

“Our results suggest that self-induced panic is a critical component of both the current financial crisis and large single day drops over recent years,” the researchers wrote in their study. “The signature we found, the existence of a large probability of co-movement of stocks on any given day, is a measure of systemic risk and vulnerability to self-induced panic. Finally, we note that the ability to distinguish between self-induced panic and the result of external effects may be widely applicable to collective behaviors.”

In the future, the researchers plan to investigate whether volatility might be a better predictor of crashes than mimicry. They note that, while volatility often increases at the beginning of a crisis, it is generally considered to be unreliable for predicting crashes.

Researchers at the NECSI also played a role in changing the market regulations during the 2008 crash. The institute advised the US Securities and Exchange commission to reinstate the uptick rule, which prohibits short selling during periods of price decreases; otherwise, short selling can further drive prices down. The uptick rule was reinstated on the morning of March 10, 2009, the day that the market began to rise.

Explore further: Heat distributions help researchers to understand curved space

More information: Dion Harmon, et al. “Predicting economic market crises using measures of collective panic." arXiv:1102.2620v1 [q-fin.ST]

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User comments : 13

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SkiSci
not rated yet Feb 15, 2011
Erased comment
ereneon
5 / 5 (2) Feb 15, 2011
This makes sense actually. If people start to think a crash is happening, then their behavior is to sell, and when enough people notice the "trend" and mimic the selling, the crash really happens.
wealthychef
3.5 / 5 (2) Feb 15, 2011
What a ridiculous claim. The article should be titled "mimicry among stocks has been correlated with stock market crashes." The ability to predict is not tested yet and in fact the words "tend to predict" eliminate the predictive power.
mattytheory
4.5 / 5 (2) Feb 15, 2011
@ereneon

agreed. although, i think a lot of the problems nowadays come from computers being programmed to buy and sell stocks automatically based on share price. i am sure other indicators are used in conjunction with share price, however, if a share price falls below a certain amount i think most computers would just sell -- regardless of what the other indicators are saying -- in order to minimize personal losses but instead having the opposite impact on the market overall since everyone else is doing the exact same thing.

i think, that in order to participate in the stock market, there should be a minimum length of time for which an investor would be required to hold a stock. this would help to dramatically reduce speculation and "day trading" and get the market back to what it is supposed to be (a way to generate capital at a very low cost) instead of what it has become (another get rich quick scheme)... IMO.
antialias
not rated yet Feb 16, 2011
With computer trade this makes sense. Computers check for trend differences in different types of stocks. Based on these differences they determine arbitrage and buy or sell.

When the differences in trends become very small the algorithm becomes unstable (think small numerators and small denominators). You can see similar behavior in many chaotic systems. Shortly before a highly chaotic event (crash) there is usually a small region of extreme order.
TechnoCore
not rated yet Feb 16, 2011
@mattytheory: I'm not certain using a minimum length of time would solve the problem. It might lead to even more unpredictable behavior. In a feedback system you can get uncontrollable swaying back and forth if the update frequency is too low. Just a thought.
antialias
not rated yet Feb 16, 2011
Every feedback system has points of instability. It's innate to the formula. The Nyquist plot for closed loop systems always has poles. You can only guarantee stability within a certain range of operation. Leave that (e.g. by getting close to the poles) and the system will always start to behave in a chaotic or exponential manner.
SincerelyTwo
not rated yet Feb 16, 2011
Prevent? Hell no. These chaotic and unstable swings in overall market behavior create the level of volatility required for broad transfers of wealth. It would suck balls there was no real opportunity for a poor man to become wealthy through the market.
antialias
5 / 5 (2) Feb 16, 2011
Since the poor man does not have access to automated computer trading (and then only via proxy companies on and never on the scale that the rich do) the opposite is true. Only the rich gain by market crashes. Several small ones in selected commodities have already been engineered to that very purpose.
ereneon
5 / 5 (3) Feb 16, 2011
Putting time limits on trades to limit speculation is an interesting concept. Another way would be to make a super short term (less than 30 days lets say) capital gains tax that is very high.
mattytheory
not rated yet Feb 16, 2011
An excellent idea! It avoids the point raised by TechnoCore, which was indeed a point I had not considered, while still penalizing speculative behaviors.
Moebius
not rated yet Feb 20, 2011
So if the crashes are driven by mimicry and they create a website to inform investors of when a crash is impending and enough investors are watching it, wouldn't this increase the mimicry and hasten a crash?

Also it sounds suspiciously like they are talking about movement that is reflected in the averages like the DOW.
nickelsworth
not rated yet Feb 21, 2011
I see a very corrupted sine wave. The monetary and stock market policy all over the world has followed the advice of the stabilizers for a great many decades. The market does indeed have cyclic nature and it is greatly influenced by the stabilizers! 'Mimicry' is a great word for it. When the stabilizers yawn, they expect us to do the same. It's human nature. That said, I propose this question; 'Is STABILIZATION CHAOS?' Hope this post has not cause you to yawn...