Yesterday, we had a reader ask us the following question,

e had the tech bubble – marked by people buying stocks that had no earnings.  We had a housing bubble – marked by the subprime debacle.  My question is where is the next bubble, how can I play it in the initial phase to benefit from its formation and what would the signals be going forward that would alert me to the fact that it’s time to lighten up?” 

In yesterday’s post, we said we’d tackle the answer in two parts, but also made some important prefacing comments.  If you didn’t read those, you should do so by clicking here.  Coincidentally, the Wall Street Journal also ponders this same question in this morning’s Heard on the Street Column.  (Readers will need access to the WSJ online to access the column.) 

What is a Bubble, Anyway?

While bubbles almost create short term messes, they are also very good at pointing to where we’re headed as a society.  In fact, bubbles may be the very thing that allows these trends to become so ubiquitous in the first place.  (Think electricity, railroads, technology etc…)

It is important to recognize that bubbles are caused by too much money chasing the same investment opportunities rather than the simple existence of such things as high p/e ratios.  High p/e ratios may have alerted one to the tech bubble, but they likely wouldn’t have warned investors in the housing bubble, where p/e ratios remained at 10-12x earnings.  

Too much money chasing the same opportunity brings about over-investment and ultimately, negative returns for the incremental investors.  One could call a cyclical industry as one with persistent mini-bubble characteristics, but what we’re talking about here is something very different, where participation isn’t simply from industry players, but very often from the public at large.  

I wish it were easy to identify bubbles once you are in them, but in reality, it isn’t.  There is no “easy in” as we discuss today and no “easy outs” as we will discuss in part II in the days ahead.   

Where Might One Look to Find Tomorrow’s Bubbles?

So, onto the question being asked.  If bubbles are caused by over-investment, where might future bubbles develop in today’s economy?   I would say there might be two candidates, although I would guess that neither are in bubbles today.  And I provide these two areas as candidates because I think the opportunities for growth look so large, that just about anyone can get a bit giddy discussing them.  Doctors, brokers, barbers…everyone.     

The first growth theme is the same area that the Wall Street Journal happened to mention in today’s article, referenced above.  And it is in the international markets, particularly emerging economies.  With a slowdown in the U.S. economy, the relative growth prospects of places like China and India look even more attractive.  I think we can all agree that it doesn’t take a rocket scientist to recognize that the industrialization of these nations represents tremendous long term growth potential for all concerned, very similar to our own industrial revolution at the beginning of the last century.

The second theme, I would argue, might be in the technology space, particularly with respect to what I would call the mobile internet and software as a service.   While I won’t mention specific stocks, I think it is quite clear that mobile devices will continue to proliferate and that they will become increasingly sophisticated, enabling users to do more and more anywhere and anyplace.  Software as a service, though less well known, is also going to become more common.  Not only is it easier to use proprietary databases anywhere and anytime when the application is hosted on the internet, it is also much lest costly for IT departments to maintain.

In Part II, which we will post over the next few days, we will try to put some ideas out there on what the signs might be to get out, if bubbles in these two areas do form.  We’ll also make some concluding comments about the importance of diversification and understanding your exposures (knowing your risks), especially if you should choose to play ball with a future bubble…