THE BLOG

The Next Bubble Won't Be Tech Stocks Or Real Estate

02/16/2011 05:45 pm ET | Updated May 25, 2011

The prime example of a bubble that really hurt was the parabolic ascent of the NASDAQ Composite Index from a rational level of 2200 in early 1999 to the ridiculously irrational 5000 15 months later. That was vertical mania by investors out of their mind.

By the end of 2002 the value of these mostly technology issues had collapsed in panic selling that was more extreme than the buying. That was a bubble worth trillions popping.

So, too, was the mania in housing, where all reasonable expectations were obliterated by leverage upon leverage in mortgage-backed securities and derivative contracts.

This bubble was a systematic and dangerous departure from economic fundamentals into the chaos of evaporating home prices.. We are still suffering four years later from that extinguishment of household wealth -- a massive damaging loss for ordinary Americans quite soon after the Nasdaq stock market bubble.

Get the idea? Bubbles are serious when they are massive. The rule for spotting bubbles before they destroy you, says Harvard economist Ken Rogoff, is to "look for large rapid surges in leverage and asset prices, surges that can suddenly implode if confidence fades."

By this measure, then, the deterioration in Treasury bond prices, in tax-free muni bond prices and fright from the anxiety about some European sovereign bonds, like Greece and Portugal, are more signs of a rationally-proceeding bear market than a panicky bubble. At least so far. Orderly retreats are not bubbles by my standard.

Same with gold, where speculation in futures contracts have been substantially reduced (lots of leverage in futures contracts) while bullion prices are trading in a fairly boring range, since confidence in the gold bubble has eased. If gold were a bubble, it wouldn't matter what the dollar was doing. Investors would just be blown away with the urge to buy gold.

Long-term gold investors believe this mania will be triggered by a sudden aversion to dollars, a plunge in their value -- and a corresponding spike to unrealistic levels for gold. They will all be trying to get out at the same time. Good luck.

Commodities are a better candidate for a bubble, as we had one in the summer of 2008 when oil popped at $147 and fell unmercifully, taking with it some food and metals prices. Since then oil has rebounded by 21 percent, food by 35 percent, copper by 108 percent, gold by 73 percent and silver a pretty bubbly 222 percent.

It was, of course, George Soros who called gold the "ultimate bubble" when it was selling for about $1,000 an ounce. Since then, we have had plenty of volatility in commodity prices and a generally accepted opinion that the demand from emerging market nations would push prices ever higher.

What could pop the bubble would be China's failure to restrain inflation and its subsequent hard landing. The China bubble clan is watching to see if the People's Bank of China fails to prevent the bubble, in the same manner as the Federal Reserve failed to restrain the housing bubble in the US by its too massive monetary easing and low interest rates.

Ignoring asset bubbles "is a very painful way to show your disdain for macro concepts and a blind devotion to your central skill for stock picking," says Jeremy Grantham, founder of GMO, the highly reputed Boston investment manager.

Grantham "unabashedly" worships bubbles, reckoning it is absolutely mandatory to identify "hugely mispriced major sectors or asset classes among equities." He suggests that short-term interest rates should remain low for 8 more months, until say August or September, in his Quarterly Letter of January 2011.

The signal for an equity bubble would be the S&P 500 index rising to 1500 and rising short term interest rates. "I still don't understand how the U.S. could have massive numbers of unused labor and industrial capacity yet still have peak profit margins. This has never happened before."

The real quandry, my friends is: When does an overpriced market become a bubble? After all the investors shifting out of Treasuries into common stocks finally rebalance their portfolios, only to get killed again?