June 2024


Dynamic warp analysis: A new approach for detecting and timing bubbles

Our Markets and Financing Research Retreat offers a wide range of academic expertise and timely market insights.

History can help us understand future stock price bubbles, but it requires learning how to bend time. Thankfully, a method called dynamic time warping offers a solution.

During the State Street Markets and Financing Research Retreat in Boston, Mark Kritzman, chief executive officer at Windham Capital Management and a State Street Associates founding academic partner, demonstrated how to detect price bubbles and anticipate their progression.

Kritzman's research, conducted along with Huili Song, quantitative researcher at State Street and David Turkington, head of State Street Associates, introduced the concept of dynamic time warping, a technique originally used in speech recognition, to synchronize the evolution of stock price bubbles that often follow irregular patterns.

Stretching and shrinking the timeline of thousands of bubble events, and systematically placing them side by side, reveals more commonalities in their attributes' patterns than a calendar view suggests. The analysis allows one to assess the likelihood of a developing bubble and identify its lifecycle stage, from inception to peak to conclusion.

“We can determine the onset of a bubble and tell you how far along it is in its journey in a way that will enable you to profit,” said Kritzman, who is also a faculty member at MIT Sloan School of Management.

His research shows that a simple trading rule seeking to invest in bubble run-ups and post-crash overreactions, while avoiding the peak, generates compelling performance in out-of-sample back tests.

By applying this technique, investors gain insight into the various stages of a bubble's journey.

Other takeaways from the research include:

  • Dynamic time warping offers a new approach to detecting and timing stock price bubbles, providing insights into their early, middle and late stages
  • Bubbles exhibit irregular patterns and different durations, making them challenging to analyze using traditional methods
  • The methodology involves rescaling bubbles into synchronized units, revealing common characteristics and facilitating predictions about bubble advancement
  • By constructing market-neutral portfolios based on bubble characteristics, investors can capitalize on bubble dynamics while managing risk effectively
  • The research indicates the potential to detect bubble onset and progression, offering valuable insights for individual stock selection and sector allocation

Dynamic time warping provides investors with a powerful synchronization tool for observing individual stock price trajectories, even during high volatility, thus offering practical insights for better decision-making.

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