Kevin Duffy on bubbles

The conditions for a bubble are in the eye of beholder, I suppose, but here are the four I look for:

1. Parabolic rise in prices and/or related metrics
2. Valuations that detach from underlying fundamentals
3. Broad public participation (subjective and can vary from a narrow company- or industry-specific bubble to a full-blown mania)
4. Rationalizations for the boom and/or high valuations continuing (“it’s different this time”)

The bubble can manifest itself in price (e.g., tech, Internet and growth stocks in 2000) or earnings (e.g., homebuilding stocks in 2005, credit-related stocks in 2007, commodity-related stocks in 2008). One should also see signs that economic actors are changing their behavior (e.g., demand destruction, college students flocking to an industry, families melting down their silverware, criminals stealing D-RAM chips, etc.). The ultimate test of a bubble is after the fact: in real terms all of the gains of the bubble period are wiped out.

~ Kevin Duffy, Bearing Asset Management, November 17, 2008