WSJ – Bubbles

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Here’s a great article on bubbles from Friday’s WSJ. I think this is a great definition of just exactly what a bubble is, whether tulip bubble or dotcom bubble:

Bubbles emerge at times when investors profoundly disagree about the significance of a big economic development, such as the birth of the Internet. Because it’s so much harder to bet on prices going down than up, the bullish investors dominate.

So you need uncertainty, but more of the talk needs to be optimistic than pessimistic.  The optimists  really play on the uncertainty as a reason for the valuations, and the pessimists are silenced by the lack of evidence.

Once they get going, financial bubbles are marked by huge increases in trading, making them easier to identify.

Also:

“The two most important characteristics of a bubble,” says Wei Xiong, are: “People pay a crazy price and people trade like crazy.”

I don’t think anyone watching the dotcom’s in the 90’s, china in the 03-06, and dare I say commodities in the last few years would deny this. I would argue that bubbles are easier to spot than we think.  If you are removed from greed, and able to stay somewhat rational, bubbles are usually very obvious.  Was it really reasonable to say that the value of your home would never go down? Of course not.  Was it reasonable to say that pets.com was worth $10B with no revenues? No way.  But the problem is no one wants to be left behind.  When your cab driver tells you about how much money he made in internet stocks, it’s officially a bubble. So if people are able to call a bubble, why can’t they trade it effectively?

Manias can persist even though many smart people suspect a bubble, because no one of them has the firepower to successfully attack it. Only when skeptical investors act simultaneously — a moment impossible to predict — does the bubble pop

It is only when prices start to fall heavily that bears can really start to come out and play, further accelerating the sell-off.  This, according to the article, explains why things seem to go down so much faster than they go up.  It’s really a rapid switch from greed to fear.  People start looking to get out at any cost because the fear of losing their money is overwhelming.  So are there any bubbles today?

I think so, although nothing is quite at that mania level…yet.  I do believe that for the moment some commodities have gotten ahead of themselves in terms of price.  I think that oil, for example, seems to fit the definition of a bubble…solid fundamentals (can anyone really argue the fact that there is dramatically increased demand on a finite supply?), rapid trading, and incredible gains.  On top of all that it seems just about every “expert” out there will tell you that oil is going higher.  Based on the little I know, this seems like a bubble to me.  The article says:

Today, there’s disagreement over commodity prices: to what extent do they reflect fundamentals like Chinese demand, and to what extent investment mania? Trading points toward a bubble: Daily volume on crude-oil contracts is running 50% above last year. Yet the initial findings of work Mr. Hong has done with Motohiro Yogo of the Wharton School — comparing cash prices and futures prices — suggest that “prices for commodities are expensive,” but not a bubble, Mr. Hong says.

I guess another bit of evidence that suggests a bubble is that there some bears out there who would like to short oil (at least in the short term…myself included) but are simply afraid.  They (we) believe the price is a little ahead of itself and is due for a pullback, but the bulls are just piling on to quickly.  It really seems to be running out of control.

Anyway, for me the most the interesting thing about all of this is that you can talk numbers, charts, pe’s, trends, etc all you want but at the end of the day the market moves because of people, and people act in a very predictable, yet irrational, way.  The stocks change, the success metrics change, the valuations change, and the businesses change, but people still are people…driven by greed and fear.   If you can figure out how to read these signals objectively in the market, you can really become an expert investor.  I’m trying to develop a better system here.

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