Investors, Beware the Lure of a Bubble

AT THIS SPRING'S auctions of contemporary art, a portrait by Lucian Freud sold for $33.6 million, a record for a living artist. A Francis Bacon triptych fetched $86.3 million, a record for a contemporary painting. A vacuum cleaner encased in Plexiglas by Jeff Koons went for $11.8 million.

The experts say there are perfectly rational reasons for these eye-popping prices: There's only so much museum-quality contemporary art, and there's an exploding population of global billionaires who want it, such as Russian oligarch Roman Abramovich, who bought both the Freud and the Bacon for his London town house. It's a simple case of supply and demand.

I'm sure that was also true for the 17th-century Dutch tulip bubble, which stands as the prototype for all investment manias. From our distance of several centuries, when even relatively exotic tulip varieties sell for under $1 a bulb, the tulip bubble seems both quaint and absurd. How could anyone risk a fortune on a tulip? Yet at the time, tulips seemed exquisitely beautiful and rare, and a growing mercantile class had the means to bid up their prices. No one then realized how easy it would be to propagate tulips, leading to a glut and the collapse of the bubble.

Investment bubbles have been on my mind as oil and commodity prices hit all-time records, something that's hard to ignore every time you fill the tank. Prices aren't just inching up to new highs. They're leaping. By June, oil had risen 39 percent in 2008 alone, on pace to more than double this year. Energy shares have responded accordingly.

This has provided a significant boost to my stock portfolio and to my overall investment returns. Fortunately, I've been recommending energy and commodity stocks for a long time, as part of a greater allocation to raw materials and as a hedge against inflation. I did occasionally take some profits, but I always bought more when oil prices were low. That approach worked well for years, but as I reported in an earlier column, it depended on "normal" fluctuations in oil prices, not a near-straight climb to record highs.

Still, in recent months I've been doing what has always been deemed the prudent thing, which is to occasionally rebalance my allocation to raw materials. In January, with oil prices hitting the $100-a-barrel milestone, I let my long-term Chevron calls expire. In April, with oil up another 20 percent, I sold some out-of-the-money covered calls on my holdings in Suncor Energy (SU) and BHP Billiton (BHP), realizing what I considered at the time a tidy sum for what I considered a conservative strategy.

Never has the market moved more forcefully against me. In the days after I sold those calls, oil seemed to jump about $3 a barrel each day. Over the next couple of weeks, it broke through the $130 mark. Suncor shares went from $120 to over $140, soaring past my strike price (and, later, splitting). BHP leaped from $85 to $94, nearly reaching my strike price of $95. The SU calls I sold don't expire until September, but in that short time frame, they had nearly doubled in value. Somebody was potentially making a lot of money, but not me.

I never expect to sell at a precise market top or buy at a bottom, and using my overall system for buying and selling, I've often been a little early. It's paid off in the long term, so usually, this doesn't bother me. But the speed and magnitude of this setback were different. I found myself brooding over my bad timing. Calls you've sold are carried on your account statement at negative their current price, so these were a daily reminder of what I could have sold them for if I'd just waited a few days longer. I found myself thinking about buying them back, even though that would represent a real loss, as opposed to the paper loss reflected on my statement. As I watched CNBC while exercising on the treadmill, I heard one guest after another boasting about his killing in oil stocks and how he was still long on the sector. I thought about buying more SU and BHP shares or buying other commodity stocks, even though this goes against my cardinal rule of investing, which is to buy when prices are low.

In other words, I was enmeshed in classic bubble emotions.

What defines a bubble? According to Hong and his colleagues, it starts with a development with far-reaching, perhaps unknowable, implications, like the debut of a new technology. Opinion may be sharply divided between optimists and pessimists, but optimists gain the upper hand, driving prices higher. Short sellers (pessimists) get squeezed and are forced to cover, retreating to the sidelines. With optimism unchecked and buying reinforced by ever rising prices, stock values become detached from any rational criteria. Trading volume surges. Eventually, optimism runs its course, prices turn down, and no one steps in to buy. Then prices collapse.

How do energy stocks and commodities measure up? The big development with far-reaching implications is the rapid growth of emerging economies, especially India and China, and a resulting insatiable demand for raw materials. Optimists have certainly gained the ascendancy, with short sellers seemingly sidelined. Trading volume has soared, with once obscure Brazilian miner Vale (RIO) now one of the most widely held stocks in America. Have prices become detached from reality?

That, of course, is the big question, and not even the Princeton experts can answer it definitively. Unfortunately, all bubbles are different, and this one, if it is one, is much different from the Internet-driven technology bubble. There's nothing new about oil and other raw materials; this isn't like the invention of the steam engine, or the railroad, or the automobile. Many of the stocks caught up in the boom aren't startups with no profits but bright prospects; they're pillars of the corporate establishment with enormous earnings. Tulips and Internet ideas may be infinitely replicable; the earth's resources are finite, even if their extent is unknown.

From my perspective, I'm more interested in my realization that as an investor, I was experiencing bubble-like symptoms. I embraced all the arguments that there was a new energy paradigm. I ignored my rational concerns that shares in the sector had risen too far, too fast. I found myself regretting my disciplined decisions to periodically take profits and rebalance. I found myself resenting my lost profits and feeling envious of people who were making a killing. Even though I've sworn that I wouldn't, I displayed the symptoms of one of the deadly sins: greed.

So here's my plan. I will not buy back those calls. If they expire at or above the strike price, I'll deliver the shares and be grateful for my profits. I am not buying energy or commodity stocks with prices at record levels. If prices continue to soar over the next few months, I will sell more.

Nor will I be bidding at contemporary-art auctions. On the other hand, while I may not be Jeff Koons, I, too, have a vacuum cleaner I'd be happy to put under glass. Let me know if you're interested.

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