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E-mini SP500: 04/01/2010 - 12/03/2010 (daily data)

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is forming in the Emini-SP500 , starting from the beginning of February 2010.

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A MINI BUBBLE IN THE SP500 READY TO BURST?

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Talking with some friends of mine, we discussed the possibility that a possible (mini) bubble
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E-mini SP500: 08/02/2010 - 12/03/2010 (hourly data)

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Therefore I decided to use the famous Log Periodid Power Law by Johansen, Ledoit and
Sornette (2000) to model this possible bubble. I choose this model because it is one of the very
few quantitative models which was able to predict the end (or slow deflation) of financial
bubbles with a good degree of success, both ex-ante and ex-post:

ln p (t ) » A + B(tc - t ) b [1 + C cos(w ln (tc - t ) + f ] (1)

where t < tc is any time before the bubble, A > 0 is the value of ln(p(tc)) at the critical time, B <
0 the increase in ln p(t) over the time unit before the crash if C were to be close to zero, C¹0 is
the proportional magnitude of the oscillations around the exponential growth, 0<β<1 should be
positive to ensure a finite price at the critical time tc of the bubble and quantifies the primary
power law acceleration of prices, tc > 0 is the critical time, w is the frequency of the oscillations
during the bubble, while 0 £ f £ 2p is a phase parameter

Even though eq. (1) can be estimated by Nonlinear Least Squares, I resorted to the Taboo
Search (TS) algorithm by Cvijovic and Klinowski (1995), “Taboo search: An approach to the
multiple minima problem”, Science, 267(5), 664-666, as well as the Pure Random Search (PRS,
with 1 million draws).

These algorithms do not need the computation of gradients and hessians, and are usually
preferred for highly nonlinear functions, see Sornette (2003) Why Stock Markets Crash? (Critical
Events in Complex Financial Systems), Princeton University Press, as well as Jiang, Zhou,
Sornette, Woodard, Bastiaensen and Cauwels (2009) “Bubble Diagnosis and Prediction of the
2005-2007 and 2008-2009 Chinese stock market bubble”, http://arxiv.org/abs/0909.1007
I fit the LPPL formula (1) to the hourly data of the E-mini SP500, using a rolling
estimation window of 250 data to be robust against parameter variation,
considering both the TS and the PRS algorithms.

Given the stochastic nature of the initial parameter selection with the TS and PRS
algorithms and the noisy nature of the underlying generating processes, after
saving the parameters that minimized the cost function, I re-estimated the model
a large number of times in order to build an empirical distribution for the
estimated parameters.

The estimation results were then filtered by the following LPPL conditions, which were
also used in Jiang et al. (2009) for the case of Chinese bubbles: tc > tN (where tN is
the last observation in the estimation sample) , B < 0 and 0 < b < 1
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Estimated Tc
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1st quartile (10.1741)

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3rd quartile (10.2080)

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Recursively Estimated Critical Time tc (hourly data)

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Median (10.1892)

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(The time index t on the vertical axis is converted in units of one year, so that 1 day = 1/365=0.002739… of the year)

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exp(A)
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1st quartile (1127)

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3rd quartile (1198)

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Median (1145)

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Recursively Estimated exp(A) » p(tc) , (hourly data)

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 Summarizing: considering the 1st quartile / 3rd quartile, the estimated critical time tc
ranges (approximately) from March the 5th 2010, till March the 17th 2010, with a
median close to March the 11th 2010, (while the mean is close to March the 13th
2010).

As for the estimated value of the price at the critical time, that is p(tc) which is
approximately equal to exp(A), it ranges between 1127 and 1198, with a median of
1145.

While many analysts highlighted that the equity markets are strongly overvalued, it is
rather dubious whether the Fed and the American Administration would
appreciate a renewed market downturn (particularly before the mid-term
elections).

Nevertheless, it is also true that the US (…and all the rest of the planet) has to place
and roll over trillions of public debt in the next months, so a (maybe limited)
market downturn could be beneficial in this regard.

Well, time will tell whether this approach was a good one in this occasion, or not. As
for my myself I did it for curiosity … and for fun, too.

DISCLAIMER: The content of this presentation is provided as general information only and should not be taken as investment advice. All content shall not be construed as a recommendation to buy or sell
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