# An agent-based early warning indicator for financial market instability

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## Abstract

Inspired by the Bank of America Merrill Lynch global breath rule, we propose an investor sentiment index based on the collective movement of stock prices in a given market. We show that the time evolution of the sentiment index can be reasonably described by the herding model proposed by Kirman in his seminal paper “Ants, rationality and recruitment” (Kirman in Q J Econ 108:137–156, 1993). The correspondence between the index and the model allowed us to easily estimate its parameters. Based on the model and the empirical evolution of the sentiment index, we propose an early warning indicator able to identify optimistic and pessimistic phases of the market. As a result, investors and policy-makers can set different strategies anticipating financial market instability. Investors can reduce the risk of their portfolio while policy-makers can set more efficient policies to avoid the effects of financial instability on the real economy. The validity of our results is supported by means of a robustness analysis showing the application of the early warning indicator in eight different worldwide stock markets.

## Keywords

Herding behavior Kirman model Financial market## JEL Classification

G10 C61 D84## Notes

### Acknowledgements

The authors are grateful for funding from the Universitat Jaume I under Project UJI-B2018-77, the Generalitat Valenciana under Project AICO/2018/036, and the Ministerio de Ciencia Inovación y Universidades under Project RTI2018-096927-B-I00. David Vidal-Tomás acknowledges financial support of the Spanish Ministry of Education (Grant No. FPU2015/01434), and he is also thankful to the Dipartamento di Scienze Economiche e Sociali of the Università Politechnica delle Marche for its hospitality during the early stage of this investigation.

## Supplementary material

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