Improving the Process of Early-Warning Detection and Identifying the Most Affected Markets: Evidence from Subprime Mortgage Crisis and COVID-19 Outbreak—Application to American Stock Markets

Abstract

Stock-market-crash predictability is of particular interest in the field of financial time-series analysis. Famous examples of major stock-market crashes are the real-estate bubble in 2008 and COVID-19 in 2020. Several studies have studied the prediction process without taking into consideration which markets might be falling into a crisis. To this end, a combination analysis is utilized in this manuscript. Firstly, the auto-regressive estimation (ARE) algorithm is successfully applied to electroencephalography (EEG) brain data for detecting diseases. The ARE algorithm is employed based on state-space modelling, which applies the expectation-maximization algorithm and Kalman filter. This manuscript introduces its application, for the first time, to stock-market data. For this purpose, a time-evolving interaction surface is constructed to observe the change in the surface topology. This enables tracking of the stock market’s behavior over time and differentiates between different states. This provides a deep understanding of the underlying system behavior before, during, and after a crisis. Different patterns of the stock-market movements are recognized, providing novel information regarding detecting an early-warning sign. Secondly, a Granger-causality time-domain technique, called directed partial correlation, is employed to infer the underlying interconnectivity structure among markets. This information is crucial for investors and market players, enabling them to differentiate between those markets which will fall in a catastrophic loss, and those which will not. Consequently, they can make successful decisions towards selecting less risky portfolios, which guarantees lower losses. The results showed the effectiveness of the use of this methodology in the framework of the process of early-warning detection.