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

Tyranny of the Dragon King 
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tulips bulbs are typically planted in the fall and then harvested in 
the late spring. But winter was the prime time for speculation because 
this was when would-be investors had the least information about the 
supply for the coming year: the old bulbs had been planted but the new 
bulbs and cut flowers were not yet available. It was during the winter of 
1636–37 that tulip mania (as it is now called) reached its height. that 
winter, a single bulb sold for as much as 5,200 guilders (more than 
$60,000 for one tulip bulb!). And then one day in february 1637, at 
an otherwise ordinary tulip auction in Haarlem, the bidding stopped 
too soon. Apparently no one had invited the next batch of tulip fools. 
that day, prized tulips sold for just a fraction of what they had even 
one day before. Panic spread quickly, and within days prices had fallen 
to less than 1% of their height. fortunes that had been made overnight 
vanished by morning. the dutch economy teetered, until ultimately 
the government needed to intervene.
Herding and similar phenomena — the kinds of behavior that lead 
to bubbles — seem to be an ever-present aspect of human psychology. 
no one wants to be left out, and so we tend to copy one another. or-
dinarily, though, we do not act like lemmings. even if we look to one 
another for guidance, we do not usually follow blindly. the question, 
then, is why under some circumstances herding seems to take over. 
How does something like tulip mania strike? When do the normal 
mental brakes that would keep someone from spending his entire 
life savings on a tulip bulb give out? Sornette doesn’t have an answer 
to this question, though he has developed some models that predict 
which circumstances will lead herding effects to become particularly 
strong. What Sornette can do is identify when herding effects have 
taken over. this amounts to identifying when a speculative bubble has 
taken hold in a particular market and to predicting the probability that 
the bubble will pop before a certain fixed time (the critical point).
despite Sornette’s enormous productivity in finance, he resists the 
idea that he has “switched over” to economics. Since 2006, he has 
held the chair of entrepreneurial risks at the Swiss federal Institute 
of technology in Zürich (usually abbreviated etH Zürich) — his first 
finance-related academic position — but he maintains a part-time po-
sition in geophysics at UcLA, and also a full-time appointment as a 

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geophysicist in etH Zürich’s physics department. He continues to 
write articles and supervise students in both fields. And if you ask him 
what prompted the change in focus of his work, since surely there was 
a shift in the mid-1990s when he began working on new topics, he 
replies, with some bewilderment, that he has always been interested in 
such things. After all, he is interested in everything.
Still, he does think there is something special about finance and 
economics. Many people go into science because of some urge to un-
derstand how the world works. But, Sornette believes, the physical 
world is only part of the story. He is just as interested, perhaps more 
interested, in how the social world works. Gravity may keep the planet 
in orbit, but, as the emcee in the musical Cabaret sings, money makes 
the world go round. And financial markets determine how money 
flows. As Sornette puts it, finance is the “queen, and not the maid.” It 
controls everything. And whatever your political position on the role 
of financial markets in global geopolitics, Sornette believes that the 
very fact that financial markets and the people who run them do have 
so much social power is a sufficient reason to look closely at how they 
work.
Since first predicting the october 1997 crash, Sornette has had a re-
markable track record of identifying when market crashes will occur. 
He saw the log-periodic pattern in advance of the September 2008 
crash, for instance, and was able to predict the timing. Similarly, the 
1998 collapse in the russian ruble that brought Long-term capital 
Management to its knees showed the signs of an impending crash —
indeed, Sornette has claimed that even though the largely unantici-
pated russian debt default may have triggered the market turmoil that 
summer, the crash showed the log-periodic precursors characteristic 
of herding behavior. this means that a market crash would likely have 
occurred during that period whether the ruble had collapsed or not. 
the balloon was already in a primed state; russia’s default was just the 
pinprick.
He has had success predicting other crashes, as well, most notably 
the dot-com crash that occurred in 2000. over several years in the late 
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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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