Protect Your Investments Against a Bubble, Know What Makes a Bubble

NEW YORK ( TheStreet) -- Friday on CNBC's "Fast Money Halftime Report", the gang had a discussion about whether biotechnology is now in a bubble because of how well it is done this year. The iShares Nasdaq Biotechnology ( IBB) ETF is up 49% this year compared to a 23% gain for the SPDR S&P 500 ( SPY).

"Fast Money" Contributor Stephen Weiss noted that the biotech industry in not in bubble territory noting the Amgen ( AMGN) is trading at 15 times next year's earnings and that Gilead ( GILD) is only trading at 10 times 2015 earnings estimates. He also cited the Affordable Care Act as a catalyst for earnings growth. Pete Najarian echoed Weiss' sentiment.

Simon Baker made a thin argument talking about the speculation built into current prices, essentially saying biotechs will fall more than the rest of the market when the market eventually corrects. Weiss and Najarian refuted him by sticking to the valuation argument these are not Netflix ( NFLX) was blurted out in the middle of the exchange.

The conversation missed the most important point which is that bubbles are not about valuation or simply a stock or industry group being up a lot. Bubbles are about investor psychology and have widespread consequences after they pop.

In early 2008, I was on CNBC for a segment about whether solar stocks were in a bubble. I was invited on thanks to a negative article on the group I wrote for TheStreet.com. Solar stocks had been white hot at the time. When asked if solar stocks were a bubble, my reply was no they are a mania. The entire market cap of the industry was about $100 billion and I noted that if they all went down a lot in price there would be no impact on society.

During the Internet bubble there were dozens of individual companies with little to no revenue or earnings that had market caps greater $100 billion or put another way, many individual companies were larger than the size of the entire solar industry at its peak.

In thinking about the tech wreck and the housing bubble, both had far reaching consequences; the Internet industry grew to have a combined market cap in the trillions of dollars and home values affect 2/3 of the U.S. population.

Any industry, including biotech, will rotate in and out of favor relative to a broad benchmark like the S&P 500. This year biotech is ahead of SPY, in 2009 biotech lagged far behind the broad market. This is normal market behavior and the next time the stock market falls a lot there will be sectors and industries that fall more than the overall market and some that fall less. The ones that fall more, maybe biotech, won't necessarily have been bubbles.

Bubbles are psychological events. Internet companies were going change the world in the future and so investors adopted a willingness to value those companies on non-traditional metrics, most notably eyeballs and investors were willing to speculate on them for fear of missing out.

The housing bubble was similar. Loans were being granted on less stringent requirements and people became far more willing to speculate on house flipping and were able to learn how to flip house thanks to a deluge of TV programs on cable TV.

During the Internet bubble, investors came to expect compound annual growth rates of 20% to 30% and in defending the housing market six years ago many serious analysts pointed out that there had never been a national decline in housing prices. Both sentiments were transformational shifts in psychology and both had severe consequences.

True bubbles are always obvious in hindsight but are difficult to detect during their build up. Instead of trying to find the next bubble investors would be better served to manage the risk they take in their portfolios by never allocating more than 20% to any one sector, more than 10% to any one foreign country or more than 5% to any single stock.

Additionally, remaining disciplined to your investment strategy during times of market turmoil is crucial. When the stock market goes down a lot it eventually comes back. After the tech wreck it took seven years and after the financial crisis it took five years but it came back. The people most damaged were the ones who sold after the large declines. There is no strategy planned out ahead of time that calls for selling after large declines. The people who remained disciplined, who did not panic were not permanently damaged by either bubble.

The next true bubble will be very similar. Most will not see it coming, the market will go down a lot, some people will panic and then after some number of years the market will have recovered.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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