The Financial Crisis Observatory (FCO) at ETH Zurich, formed by Didier Sornette, has developed models for identifying bubbles in financial market indices, sectors, and stocks through what it calls the FCO Cockpit. Given a well-established model based on price with explicit probability measures for a market reversal, the FCO can identify financial markets that are likely in a bubble state by looking at price behavior.
In reality, there are bubbles all over the world in many markets. There have been significant positive bubbles with large market increase as well as large negative bubbles from extreme market declines. Unfortunately, there has not been a generally accepted definition of what is a financial bubble. Bubbles are more frequent than what you may think as measured by the FCO.
The FCO uses a model that can identify bubbles which also have a high likelihood of bursting through a change in regime. The model looks for price characteristics of a hyperbolic power law and distinct oscillations that usually lead to a price behavior adjustment, reversal, or crash. Simply put, markets that are rising faster than an exponential with greater oscillations are candidates for a bubble. When these characteristics exist, there is a high likelihood of a reversal. What cannot go on for long, will not.
While the fitting of this model is not easy, it provides a framework for comparing large numbers of markets in order to identify bubbles through only looking at price data and not relying on some fundamental valuation or model framework. This is important because an investor can use the output from the FCO through their monthly FCO Cockpit -Global bubble Status Report to identify potential bubbles.