5 Could-Be Bubbles Waiting To Burst

By Stephen D. Simpson, CFA | October 21, 2010 AAA
5 Could-Be Bubbles Waiting To Burst

One of the oldest sayings of Wall Street (and one that happens to be true!) is that "there is always a bull market somewhere." No matter how bad one segment of the market may be performing, there is almost always some unrelated asset that is doing well at the same time. Taking that to its logical extreme, if there is always a bull market somewhere, there are almost always a few potential bubbles emerging. So which markets look like they have heated up to the melting point? (For more, check out The Myth About Market Bubbles.)
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Bonds
To a lot of people, the current yield on government bonds just makes no sense. These people see the federal budget deficit, the huge debt burden and the risk of a stagflation-type environment of low growth and high inflation, and cannot understand how investors could be piling into bonds. Moreover, there is a strong sense that these artificially low rates are just a prelude to a withering bout of inflation that will smack fixed income instruments hard.

For better or worse, there are other dynamics at work in the bond market. For starters, banks can make a solid "carry trade" on government bonds - banks take their ultra-low cost deposits and invest them in higher-yielding government securities.

Second, many pension funds were badly wounded in the mortgage-backed bond crunch of 2008 and 2009. Not only have many funds rewritten their mandates to take on less risk, but the supply of bonds has changed. In many cases, pension funds are buying government bonds because they need fixed income instruments and the near-collapse of the mortgage-backed securities market has eliminated that supply.

In other words, this is not so much a bubble (at least not a bubble fueled by unreasonable expectations of gain) as a supply squeeze. That is not to suggest that it could not still end badly, but the actions of many of these bond-buyers are not quite as irrational as some believe.

Rare Earth Elements
If there is a bubble in rare earth metals, China is likely to blame. Not only does China have the blessing of favorable geology (ample resources), but the country actively supported its rare earth mining operations at a time when Western miners were closing up shop. Now, though these elements are critical components of many electronics, China overwhelmingly controls the supply, and the government is curtailing exports and driving up prices. That, in turn, has created a boom time for would-be rare earth miners like Lynas (OTC:LYSDY) and Avalon (TSE:AVL).

Ironically, rare earth elements are actually not all that rare for the most part - they are just difficult to find in concentrated quantities on their own, and are typically the byproduct of other types of mining. At prevailing prices, miners are scrambling throughout Australia, the United States and Canada to bring old mines back into production and begin mining new resources. Simultaneously, those companies that depend upon rare earth elements are doing what companies always do when a key component gets expensive and/or scarce - they are engineering around the problem.

Although rare earth prices could stay high for a while (mines do not open overnight), new digging and new alternatives are likely to put an expiration date on this bull market.

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Cloud Computing
If there is a candidate for a good old-fashioned stock bubble, the cloud computing area is as good as any. Some of the requisite hyperbole is certainly in place - namely, that cloud computing is going to revolutionize how businesses approach IT, and how it is going to permanently disrupt the software industry.

Although many of these stocks have recently retreated from their highs, the valuations are still impressive. Salesforce.com (NYSE:CRM) carries a trailing enterprise value-to-revenue multiple of 9.5, while VMWare (NYSE:VMW) trades at a multiple of 12.3, Citrix Systems (Nasdaq:CTXS) at 5.9 and LogMeIn (Nasdaq:LOGM) at 8.3. While this entire sector is seeing robust revenue growth and customer demand, that was also once true for a host of networking, semiconductor and e-commerce stocks back in the late 1990s. (For more, see Is Cloud Computing An Investable Trend?)

Cotton
Amidst all of the hoopla about the performance of grains, base metals, precious metals and even cocoa, the record prices in cotton have gone almost relatively unnoticed. Nevertheless, cotton recently broke an all-time price record and prices have jumped about two-thirds from mid-summer.

Unfortunately for investors, the odds are that this cotton bull market has short legs. There is little that can be done to boost supply in the short-term, but high prices for cotton will do what they always do - stimulate more planting in cotton-growing regions. Although it is always possible that growing conditions (poor weather, etc.) could damage the next crop(s), it is likewise possible that journalists will be talking about a bumper crop and low prices this time next year.

Gold
The ultimate "is it or is it not" bubble argument has to be over gold. September and October have been full of reports talking about record high prices for this precious metal, and the overall trend has been up for roughly eight years now. Despite this momentum, plenty of gold-bugs will step up to remind the market that gold has yet to reach an inflation-adjusted record of about $2,200 per ounce.

Although gold is often hailed as an inflation hedge, the data supporting that is less than fully compelling. What gold really seems to hedge is uncertainty; when people get nervous, they like to hold gold. Relative to the trajectories seen in the tech stock and housing bubbles, gold could still have a ways to go - particularly for those who see chaos in the political and economic conditions of the U.S. and Western Europe.

There is, however, an inconvenient truth - hardly anybody outside of coin dealers has ever made lasting wealth out of trading in gold. As gold skeptics love to point out, gold produces no income, is inconvenient to use as is, and could very well be seized by governments during the very conditions that gold-bugs point to as an argument in the metal's favor. While the ubiquity of fear in the market seems to justify a lot of the enthusiasm for gold, it is hard to see how prices are not overheated - to say nothing of the fact that if economies fail and governments collapse, people will have more to worry about than their 401(k)s.

The Bottom Line
"Bubble" has become an overused term in the last few years, as many investors and commentators now slap that label on any market segment that has enjoyed strong appreciation and high valuations. True bubbles are supposed to involve a certain element of self-delusion and mania. For an overheated market to really be a "bubble", there needs to be a collective notion that "it's different this time" and that the only prudent move for savvy investors is to put nearly all of their money in that asset - that was the prevailing sentiment during past bubbles like the South Sea craze, Tulip Mania, the margin-fueled stock bubble of the 1920s, the Nifty Fifty and the tech bubble of the late 1990s.

Whatever terms one wishes to use, though, there is no question that there are some overheated segments of the market today. While momentum investors may be tempted to play their luck and see if they can squeeze more profits from these runs before the flag, more conservative investors may want to give them a pass altogether. (For an in depth look at some historical market bubbles, check out our Market Crashes Tutorial.)

For the latest financial news, see Water Cooler Finance: The Beginning Of A Foreclosure Crisis?

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