Bubble, Bubble, Toil and Trouble

Carl Futia makes an excellent point about all the bubble talk on his blog.  It seems everything from oil stocks (UPL), to Internet stocks (GOOG), to real estate (any REIT) is being described as being in a bubble by the financial media.  He sees it as a sign of pessimistic sentiment towards financial assets, which is actually very positive for continued price appreciation from a contrarian standpoint. 

I agree.  If investor sentiment were overly optimistic, what is currently being described as a "bubble" would instead be described as a "boom."  A "bubble" carries with it negative connotations that prices are unsustainably high.  A boom, on the other hand, carries positive connotations of wealth and prosperity.  Therefore, I think the "bubble" won’t turn into a true "bust" until most investors think of it as a "boom", if that makes any sense at all. 

Its very similar to the attitude towards stocks in 1983 and 1984.  Even back then the bubble moniker was thrown around by the financial press after the "oil bubble" burst in the early 1980s.   Investors hadn’t seen rising stock prices in so long that they automatically assumed higher prices were unsustainable and representative of another bubble.   

However, just because prices are rising at an above average rate, doesn’t indicate that a bubble is developing.  According to Wharton School Assistant Professor Grace Wong, increased speculation doesn’t develop into a bubble until the number of transactions rise dramatically in the market place. 

"When there are speculative activities in the asset market, we should see an increase in transaction volume as well," explains Wong. "This positive relationship between turnover and price should be on the top of any positive relationship implied by other theories such as liquidity premium (which states that as assets are traded more liquidity, prices go up.) What I did was make use of a unique data structure that allowed me to separate these stories apart and provide evidence on whether there is speculation. The interesting thing is, the bubble grows as speculative activities build up," Wong notes. "There is likely to be some speculative demand in the market at all times, but bubbles form only when there is substantial speculation. What we can do is to keep track of changes in turnover volume, separate increases in turnover due to speculation and those due to other factors, and therefore get a sense of how much speculation there is. When there is a frenzy of trading, a red flag should be raised and we should take a careful look at the fundamentals (which are difficult to measure) and housing prices." 

Her explanation of real estate bubbles coincides well with the experience of the tech stock bubble in 1999 and 2000.  While there was certainly lots of speculation in tech stocks prior to 1999, a true bubble didn’t develop until Internet stocks started trading 5x their float every day. 

I think there’s enough real estate "flipping" going on that certain parts of the country are clearly in a real estate bubble (Las Vegas has probably already burst).  That’s a negative for real estate investors. 

However, I think all the bubble talk is generally a positive sign that investors still don’t trust rising prices.  Its a sign of deep underlying skepticism that won’t be cleared away until prices start rising more rapidly and converting more people from believing in bubbles to to believing in booms.