What Makes a Bubble a Bubble?

04/29/2011 7:00 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Market bubbles are widely regarded as uncharacteristic events, but a look at past history and forces at play in the current markets suggests that boom and bust cycles could become the “new normal.”

Defining a market bubble has become a bit like the moral right’s hunt for pornography. They can’t quite quantify it, but they’re sure it’s evil, it must not be tolerated, and they’ll know it when they see it!

Of these qualifications, twenty years of chart study at least allows me to agree with the last statement.

I’ve studied market bubbles from Belgian tulips to the Hunt brothers’ cornering of the silver market and actively traded the tech bubble on the way up and the way down.

We traded the economic collapse of 2008, an inward bubble, as well as the commodity bubble that immediately preceded it.

We’ve analyzed bubbles mathematically through standard deviations and statistical analysis, we’ve read university studies, which focus on the psychological aspects of the markets’ participants, and we’ve watched politicians blame it all on the speculators.

Out of all of this, there are a few things that help us understand where we are now, and that is the key to investing.

There is a difference between an individual market bubble and a rising tide floating all ships. A summer drought or a winter freeze may push grains or orange juice into bubble mode through crop damage. However, those are individual market issues.

An economic policy that devalues the dollar in the face of growing global demand is the tide that floats all ships. The US commodity markets remain the global commodity-pricing mechanism. Therefore, all commodities priced in dollars will continue to climb as long as our economy flounders, regardless of speculative trader participation.

Quantitatively, the only current market that may be headed towards the psychological bubble area is silver.

A recent survey of commodity bubbles—both up and down—does provide us with some clues towards the identification of a bubble. Typically, we see moves in excess of 100% in less than six months. The primary focus is rate of change. Bubble markets have large moves over very short time frames.

The psychological aspect is the history of human nature. Trading bubbles have been reproduced over and over in academic labs. According to a study done at the University of Zurich, human beings do tend to learn from their mistakes. They found that subjects burnt by a bubble are two-thirds less likely to be burnt by the second one.

Unfortunately, several other studies on the human decision making process have concluded that once people have acquired enough information to make an informed decision, more information only increases their level of conviction—not their accuracy.

We are just beginning to see an entirely new wave of market participants. Therefore, psychological aspects of trading will have to be learned again and again.

The growing global demand is just in its initial stages. We have seen the first leg of the new global commodity price norms. Old-world Europe is struggling, and China and India are both reining in inflation as best they can.

A near-term slowdown will prove to be a huge buying opportunity in the commodity markets by new participants in Asia and India who have seen their incomes grow threefold over the last ten years and have money that must be invested to keep pace with their domestic inflation.

They are already pushing the trading volume of overseas commodity markets to new volume records. Much of this has to do with the typically small contract sizes they trade, which broadens their appeal.

Their volume is further enhanced by political systems that won’t allow their people to invest outside of their countries. This eliminates cross hedging, which does minimize price fluctuations relative to value. Thus, a whole new population is beginning to fuel the bubble and subsequent burst cycle of their markets and financial education.

Be careful next time you hear someone mention a market bubble. It may just be the new normal.

By Andy Waldock of CommodityAndDerivativeAdv.com

Related Articles on COMMODITIES