How major market crashes around the world can be quantitatively explained.
The Chinese art and calligraphy market has been on fire. Between 2000 and 2011, the market, represented by the Chinese Painting 400 Index, gained more than 700%, or about 21% per year. More impressively, it gained about 353% from June 2009 to June 2011.
Do these kinds of extreme gains seem familiar? We have witnessed many similar asset-price bubbles. The story is the same. Positive feedback and herding among speculative investors produce runaway prices until the deviation from equilibrium is so large that the market becomes unstable, creating a high probability (or an inevitability) of a crash.
This is clearly happening in the Chinese art market. There’s certainly herding behavior and positive feedback among Chinese art investors. The past decade’s economic boom has created new wealth in China and rising demand for Chinese fine art and calligraphy, driving up prices. Increasing prices in turn attract more art investors and speculators, who are desperate to join the party. They see past price apprecia- tions and become very confident that they, too, can sell their art at higher prices than what they paid for them. And so it goes, on and on.
But when will this mania for Chinese art end? More important for us, do the Chinese art-market boom and other asset-price bubbles share the same characteristics, and do all bubbles originate in the same manner? If yes, can we identify these factors beforehand and predict when a bubble will burst?
Herd Behavior and Market Bubbles
A number of studies have considered herd behavior as a possible explanation for the excessive volatility observed in financial markets (such as Bannerjee, 1992; Topol, 1991; and Shiller, 1989).
The thinking behind this approach is simple: Interaction of market participants through herding can lead to large fluctuations in aggregate demand, leading to heavy tails in the distribution of returns. In the popular literature, “crowd effects” often have been associated with large fluctuations in market prices of financial assets.
Shiller (2000) provides massive evidence to support his argument that “irrational exuber- ance” played the role in producing the ups and downs of the stock and real estate markets. He listed 12 precipitating factors that gave rise to the booms in the stock markets and housing markets. These factors are amplified via feedback loops and naturally occurring Ponzi schemes, aided by the media, and can ultimately lead to market crashes.
Shiller also demonstrates that psychological factors, such as herd behavior and epidemics, are exerting their important effects. For example, the influence of authority over people can be enormous; people are ready to believe authorities even when they plainly contradict matter-of-fact judgment.