How to predict financial crisis – The Dragon King Theory Vs the Black Swan


Before the 2008 global financial crisis, almost everyone believed in the Great Moderation, i.e. the belief by most economists, policy makers and the like, that we are living in a never ending world of growth and prosperity. Needless to say the great crash broke this illusion. What was a few hundred dollars loss in the financial sector cascaded into a loss in GDP worth 5 trillion dollars and a loss in the global stock market worth 30 trillion dollars! Most importantly, all this happened completely out of the blue like the wrath of gods in legends, no one knew what’s going to happen and nobody was responsible!

Dragon Kings, Black Swans and Crisis prediction

Against the above background, and so that such calamity can be checked from occurrence as best as possible, the goal aims at diagnosing financial bubbles in real time and identifying their critical time in advance. A theory that helps this cause is that of the Dragon King, developed by Prof. Didier Sonnette.

The Dragon King refers to an event which is huge in size or impact like a king, and also born of a unique origin like a dragon. These events are generated by mechanisms such as phase transitions, bifurcations, positive feedback, etc which usually take place in complex non-linear systems. In simple words, these are the extreme special events. They are the outliers. However, being generated by specific mechanisms makes them predictable and at best, controllable.  So the Dragon theory basically works on the basis of two hypothesis:

Hypothesis!: Financial bubbles can be identified in real time

Hypothesis II: The end of the financial bubble can be assessed using probabilistic forecasts

If a financial time series is taken, a financial stock or a global index, there are ups and downs. A good measure of the risk for this specific financial market is the peak-to-valleys range in its graph. The worst case scenario can be where one bought at the top and sold at the bottom. The statistics, the occurrences of these peak-to-valleys, the frequency such occurrences, can all be studied and almost all the peak-to-valleys, belonging to different multitudes can be represented by one general law, represented by perhaps a bold red line on the graph.

A loss is followed by a loss

Most importantly, there are bound to be exceptions or outliers which would be located above this bold red line. And there would be innumerable occurrences of these, the frequency of which would be far greater than the extrapolation would otherwise predict on the basis of the remaining peak-to-valleys. These are basically due to the dependencies that a loss is followed by a loss which again is followed by more and more losses. These dependencies are otherwise usually missed by the common risk management tools. They see insects when there are supposed to see dragon kings!

In case of dragon kings, the mechanism is basically a gradual maturation towards instability, represented by the bubble the end point of which is usually the crash. And it is hard for standard techniques to predict such a non-linear mechanism. The core of the inner instability of the system has to be identified and the tiny causal perturbations recognized in order to get to the cause of the crash or crisis.

However, as most of you would have concluded by now that the dragon king theory is very different from the black swan concept which you keep hearing all the time. Black swan is basically a very rare bird you see probably once which shatters your inherent belief that all swans are white. In terms of the market, black swan concept reflects the ideas of unpredictability and unknowability of extreme events. Thus, the dragon king theory is completely the opposite which proposes that most of the extreme events can be known and predicted from beforehand.

The warning signals from the Dragon King

As per the Dragon King theory, there are various warning signals. For instance, a super-exponential growth coupled with very positive feedback. Let’s say, an investment that gives exponential returns to the likes of 5%, 10%, 20% & 40% in four years. Its marvelous but it’s a super-exponential bubble supported by positive feedback suggesting push forward, increase next growth, etc, all of which trenchant, however might not be sustainable.

The answer lies in the mathematical solution stating that these models are finite time series, in simpler words, there would come a critical time when the bubble will burst. It might be a plateau or a crash but the main idea is the recognizing that there is a critical time contained inherently. A similar bubble had occurred in the beginning of this century, the worldwide market overvaluation, which suddenly burst in 2007. We should not ignore the science that clearly states that in times when instability has developed, any small perturbation would be impossible to contain and control.

To conclude it can be said that human beings are still to learn how to steer their planet and society towards sustainability amidst challenges. Good governance is nothing but wise planning and prediction. And against this need, the dragon king theory provides hope that most of our systems have pockets of predictability waiting to be identified so that the great recessions and the catastrophes can be predicted, taken responsibility of and thereby, controlled.