Is the oil market forming a bubble?

Many advisers argue that it is and, therefore, conclude that oil’s price will soon plummet -- just as Internet stocks did after the dot-com bubble burst in 2000. But, what exactly is an investment bubble? And, how can we tell the difference between a market that is in a bubble from one that is merely poised for decline?

Most of us think we know the answer. In the vernacular sense in which the term is thrown around, a bubble exists whenever prices are divorced from their underlying fundamentals. In such an event, it is only “hot air” that is keeping the prices high; hence, the analogy to bubbles.

The problem with this vernacular understanding of bubbles is that it is too broad. By this definition, virtually any overvalued security can be described as a bubble. But, by saying something is in a bubble, surely we are communicating something above and beyond the idea that it is overvalued.

But, what is that “something”? And, is it fair to say that this “something” exists in the oil market?

For help in answering these questions, I turned to an essay written by James Montier, who is the Director of Global Strategy at Dresdner Kleinwort Watterstein in London and author of the 2002 book Behavioural Finance: Insights into Irrational Minds and Markets, published by John Wiley & Sons. After reviewing the academic literature on bubbles, Montier concluded that there actually are four different types of investment bubbles:

• Near Rational. In this type of bubble, investors, in effect, adhere to the so-called “Greater Fool Theory.” That is, they are willing to keep paying higher and higher prices, so long as they believe they can find someone else who, down the road, will pay even higher prices. Investors recognize and concede that they are in a bubble but are supremely confident they will be able to get out before the bubble pops.

• Intrinsic. Unlike how they behave in a “Near Rational” bubble, investors, in this case, do focus on fundamentals. The error they make is extrapolating the high rates of return of the recent past into the future, naively believing they will continue into the indefinite future.

• Fads. In this type of bubble, investors are being motivated by social and psychological factors. “People come under intense pressure to confirm the majority’s view,” as Montier puts it. This clearly played a large role during the build-up of the Internet bubble, for example, when analysts were written off as old-fashioned fuddy-duddies if they didn’t subscribe to the “new era” thinking.

• Informational. In this type of bubble, prices deviate from fundamentals because investors mistakenly assume that those prices reflect hidden information about those fundamentals. So, if prices go up, traders must know something that the rest of the market doesn’t; investors react by bidding prices up even more. Montier points out that the momentum aspects of “Informational Bubbles” make them very fragile because a “small trigger” can “engender a major change” in investor behavior.

Which of these four, if any, even potentially applies to the current oil market? I think it is easier to rule some of them out.

For example, investor behavior does not appear to be consistent with oil being in an “Intrinsic” bubble. On the contrary, it would appear that many who think oil’s price will go higher believe it will form a shorter-term spike -- jumping higher for only a brief time, triggering a serious economic slowdown, which, in turn, will cause demand for oil to plummet and bring oil’s price back down almost as quickly. This, in essence, is the argument made by the Goldman Sachs analysts who gained lots of attention recently by suggesting that oil could spike to $105 a barrel.

Nor does the oil market fit the model of a “Fad” bubble. I am not aware of any group-think suggesting oil will forever rise in price -- though, to be sure, there are some who believe it will. But, there is no intense pressure on analysts to conform to such a point of view. On the contrary, the Goldman Sachs analysts received a lot of hostile reaction when suggesting crude might be headed to $105.

Finally, we can probably eliminate the “Informational” bubble type as well. Indeed, many advisers and commentators argue that traders have not been acting on fundamental information when bidding oil’s price higher, but are merely speculating.

This leaves the “Near Rational” bubble as the one that even potentially comes close to describing the current oil market -- the one based on the Greater Fool Theory. And, it does fit in many ways. Many of those betting on oil have a very short-term focus, for example, and, to that extent, don’t care if oil’s price will someday be much lower than it is today. They are merely betting that oil’s price, over the near term, is going higher.

To say that this one type possibly applies doesn’t guarantee that oil is in a bubble, needless to say. But, it does alert you to the pitfalls of investing in oil these days.

The major error investors make in “Near Rational” bubbles is thinking they will be able to identify when the market has topped and get out before everyone else. By definition, of course, this can’t be true for the majority of investors. Yet, the bubble mentality leads investors into becoming overconfident, which, in turn, leads them to minimize risks.

If you’re betting on oil or oil-related securities, therefore, ask yourself whether any of this applies to you. If not, good for you -- you can sleep easily at night.

But, maybe, just maybe, you will want to rethink your rationale for such investments.

Mark Hulbert is editor of the Hulbert Financial Digest, a service of Marketwatch that, for nearly 24 years, has tracked the performance of investment advisory newsletters. A section of the Marketwatch website called "Hulbert Interactive" (marketwatch.com/hulbertinteractive) allows users to conduct extensive research on the HFD database.

Mark can be contacted via email at mhulbert@marketwatch.com