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

Tyranny of the Dragon King 
•
173
so widely applicable. the details are often different from field to field, 
but the principal mechanisms are not. the same phenomena affect 
avalanches, forest fires, political revolutions, even epileptic seizures.
Sornette’s first foray into economics was in 1994. He coauthored 
a paper with another physicist in france, named Jean-Philippe 
Bouchaud. that same year, Sornette and Bouchaud went on to found 
a research company called Science & finance, which in 2000 merged 
with a Parisian hedge fund management company, capital fund Man-
agement (cfM). today Bouchaud is chairman and chief scientist of 
cfM, which has grown to be the largest hedge fund management 
company in france. (He is still officially a physics professor, at École 
Polytechnique, the grande école near Paris where Mandelbrot studied; 
Sornette, meanwhile, left Science & finance in 1997.) their joint paper 
showed how to price options even if the underlying stock does not fol-
low the kind of random walk assumed by Black and Scholes. this ef-
fectively extended the theory of options pricing to more sophisticated 
models of price changes, including those with fat-tailed distributions. 
(o’connor and Associates had already done work along these lines
— but this wasn’t widely known.)
After that paper, Sornette was hooked. over the next several years, 
he read more and more about traditional economics, adding what he 
could to problems like options pricing and risk. (Sornette prides him-
self on having learned to think like an economist.) Much of this early 
work was done in collaboration with Bouchaud, who by this time was 
working on finance nearly full-time.
In 1996, Sornette’s work on earthquakes earned him a part-time 
professor-in-residence position in UcLA’s earth and space sciences 
department, and at the Institute of Geophysics and Planetary Physics. 
By this time, though, at least half of his energy was devoted to finance. 
that same year, Sornette, Bouchaud, and Sornette’s postdoctoral re-
searcher, Anders Johansen, realized that Sornette’s earlier work on 
predicting earthquakes and ruptures could be extended to predicting 
market crashes. they published a paper together in another physics 
journal. Amazingly, just a few months later, Sornette detected the log-
periodic pattern that he had determined should presage a crash. the 

---

success of october 1997 deepened his belief that he was on to some-
thing important, and he redoubled his efforts on economics and finan-
cial modeling.
As with his theories of material rupture and earthquakes, the cen-
tral idea behind Sornette’s market-crash-as-critical-event hypothesis 
involves collective action, or herding behavior. By itself, this is hardly 
surprising, as the suggestion that market crashes have something to do 
with mob psychology is old: in 1841, charles Mackay wrote a book on, 
among other things, economic bubbles that he called Extraordinary 
Popular Delusions and the Madness of Crowds. there, he pointed to 
several historical cases in which entire countries had been taken by 
some sort of frenzy, leading to speculative bubbles — market condi-
tions under which prices become entirely divorced from the value of 
the things being traded.
Perhaps the most striking example occurred in the netherlands in 
the early seventeenth century. the subject of speculation was tulip 
bulbs. tulips originated in turkey but made their way into western 
europe, via Austria, in the middle of the sixteenth century. the flowers 
were considered very beautiful and were highly prized by the euro-
pean aristocracy, but the real money was in tulip bulbs, which could 
be used both to produce the flowers and to produce new bulbs. tulips 
came to represent dutch imperial power. the country’s new merchant 
class, made wealthy by trade in the dutch east and West Indies, would 
broadcast its power and prestige with ornate flower gardens, with tu-
lips as the centerpiece.
So tulip bulbs were a valuable commodity. But how valuable? dur-
ing the 1630s, prices began to grow rapidly. By 1635, trades worth 2,500 
dutch guilders (worth roughly $30,000 in 2010 dollars) for a single 
bulb were recorded. trades of 1,500 guilders were common. In con-
trast, a skilled laborer could expect to make about 150 guilders in a 
year. Around this time, foreign money began to pour into the market 
as outsiders tried to make a quick buck in the tulip game. the dutch 
were thrilled. they took the foreign investment to mean that all of eu-
rope was catching on to their tulip craze, and so they doubled down: 
ordinary people sold their belongings, mortgaged their houses, and 
exhausted their savings to participate in the tulip market.
174 
•
t h e p h y s i c s o f wa l l s t r e e t

---