Predicting economic market crises using measures of collective panic

Predicting panic is of critical importance in many areas of human and animal behavior, notably in the context of economics. The recent financial crisis is a case in point. Panic may be due to a specific external threat, or self-generated nervousness. Here we show that the recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry — direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news. High levels of mimicry can be a quite general indicator of the potential for selforganized crises. 1 ar X iv :1 10 2. 26 20 v1 [ qfi n. ST ] 1 3 Fe b 20 11 In sociology [1–4], panic has been defined as a collective flight from a real or imagined threat. In economics, bank runs occur at least in part because of the risk to the individual from the bank run itself—and may be triggered by predisposing conditions, external (perhaps catastrophic) events, or even randomly [5, 6]. Although empirical studies of panic are difficult [7–9], efforts to distinguish endogenous (self-generated) and exogenous market panics from oscillations of market indices have met with some success [10–14], though the conclusions have been debated [15–18]. Market behavior is often considered to reflect external economic news, though empirical evidence has been presented to challenge this connection [19]. Efforts to characterize events range from the Hindenburg Omen [20] to microdynamic models [21] and to the demonstration that market behaviors are invariant across many scales [22]. Other work has looked at relationships of market behavior with internet search [23]. Panic can be considered a ‘critical transition’ for which early warnings are being sought [24]. The “collective flight” aspect of such a transition should be revealed in measures of mimicry that is considered central to panic. Here we use co-movement data to evaluate whether the recent market crisis and earlier one-day crashes are internally generated or externally triggered. Based upon a hypothesis about mimicry, we construct a model that includes both mimicry and external factors and test it empirically against the daily extent of co-movement. Our objective is to determine the relative importance of internal and external causes, and, where internal causes are important, to find a signature of self-induced panic, which can be used to predict panic. The literature generally uses volatility and the correlation between stock prices to characterize risk.[25–31] These measures are sensitive to the magnitude of price movement and therefore increase dramatically when there is a market crash. Studies find that, on average, volatility increases following price declines, but do not show higher volatility is followed by price declines.[32–36] We are interested in the extent to which stocks move together. The extent of such co-movement may be large even when price movements are small. Indeed, even when price changes are small, we expect that co-movement itself is the collective behavior that is characteristic of panic, or panicky behavior that precedes a panic. Thus, rather than measuring volatility or correlation, we measure the fraction of stocks that move in the same direction. We find that this increases well before the market crash, and there is significant advance warning to provide a clear indicator of an impending crash. The existence of the indicator shows that market crashes are preceded by nervousness that gives rise to following