The Physics of Wall Street: a brief History of Predicting the Unpredictable

Tyranny of the Dragon King 
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losses. for the first time in its history, the new York Stock exchange 
was forced to close early in order to avoid a still more severe catastro-
phe. on that day alone, over $650 billion vanished from new York’s fi-
nancial markets. International markets fared just as poorly, with sharp 
declines in London, frankfurt, and tokyo. the Hong Kong Hang Seng 
index fell 14% the following night.
Sornette and Ledoit, however, made a 400% profit. they released 
their Merrill Lynch trading statement that november to prove it. the 
crash had come, just as Sornette had predicted.
Historians now explain the worldwide crash as a reverberation ef-
fect. earlier that year, the thai baht collapsed after the thai govern-
ment decided to stop pegging it to the U.S. dollar. thailand carried 
significant foreign debt before the collapse of the currency, and af-
terward the country was essentially bankrupt. thailand’s difficulties 
quickly spread to its neighbors, earning the nickname “Asian flu” for 
the crisis because of the way it moved through Southeast Asian econo-
mies, devaluing currencies and depressing equity markets throughout 
the region. these conditions increased uncertainty in all parts of the 
world’s economy, leading to unusually high variations in the prices of 
securities. When Asian markets fell overnight on the twenty-sixth, in-
vestors in the United States reacted strongly and amplified the crash.
one of the most striking things about the october 27 crash, and the 
reason it is now referred to as a “mini crash,” is that new York markets 
rebounded the next day. By the close of trading on the twenty-eighth, 
the dow had regained 60% of the previous day’s losses. And in a strik-
ing counterpoint to closing its doors early for the first time the day 
before, october 28 was the first day that over a billion shares were 
traded on the nYSe. this kind of dramatic seesawing is telling: since 
the cumulative effect of the crash and rebound was a relatively modest 
change in prices, standard reasoning about pricing in an efficient mar-
ket does not seem to apply. that is, any theory of the stock market that 
accounts for price changes in terms of the actual values of the compa-
nies whose stocks are being traded would predict that a crash would 
correspond to some dramatic change in the real-world values. But this 
didn’t happen. Stocks were worth more or less the same amount on 
october 29 as they had been on october 26, indicating that most in-

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vestors didn’t think the values of the companies had changed all that 
much. Instead, it seems that the crash resulted from some sort of inter-
nal instability in the markets themselves.
According to Sornette and his collaborators, this is a feature that 
shows up in many market crashes. As he is fond of pointing out, the 
standard economic reasoning suggests that if bubbles are possible 
at all, they can end only with some dramatic news that materially 
changes the value of firms whose stocks are being traded. And yet, 
many economists agree that if you look at particular crashes, it is often 
very hard to identify what that piece of news could have been. Sure, 
there’s always some piece of bad news to associate with a market crash. 
But one is often stuck blaming extreme events on run-of-the-mill ex-
ternal causes that do not seem to change the value of the things being 
traded. this alone should be highly suggestive, at least to someone 
who is accustomed to thinking about critical phenomena in physics, 
because it implies that even if a piece of news is the immediate cause 
of a crash, there is something about the state of the market that deter-
mines whether the market actually crashes, or just closes a few points 
lower. And as with ruptures and earthquakes, Sornette argues, even if 
you cannot predict the news, you can try to identify when the market 
is in a precarious state. Just look for the log-periodic tremors.
critical phenomena often have what physicists call universal proper-
ties. this means that you can start with two materials that look as dif-
ferent from one another as can be — a Kevlar tank, for instance, and 
tectonic plates — and find that, despite the profound differences in 
their microscopic details, under certain circumstances they exhibit the 
exact same large-scale behaviors. Both rupture, for instance, as a result 
of prolonged strain. If you look in detail at how the ruptures occur, 
you find that the differences in the microscopic details fade away and 
the radically different materials end up acting in more or less the same 
way. there are certain universal laws that seem to apply at a statisti-
cal level. You might think of these as laws that govern coordination 
between parts, irrespective of what the parts happen to be. It is this 
kind of universality that makes Sornette and his collaborators’ ideas 
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t h e p h y s i c s o f wa l l s t r e e t

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