Is a Stock Market Bubble Brewing in Wearables Stocks?

There's plenty of buzz about wearables being the "next big thing." Plenty of tech giants, celebrities, and Kickstarter start-ups are jumping on that bandwagon with their own fitness trackers or smartwatches. There's even a new wearable device which analyzes farts to tell you what foods to avoid.

Grammy Award winner Will.i.am's Puls smartwatch. Source: Puls.com

But as shrewd investors know, when everyone is convinced that a certain category of products will succeed, a bubble could form. There's no concrete definition of a "market bubble". Some investors measure it in a disconnect between market forecasts and reality, while others measure it in soaring stock valuations. Let's take a closer look at the wearables market to see if a bubble is brewing.

Market forecasts vs. reality
The easiest way to spot a bubble is to compare long-term market forecasts to actual sales. Let's take a look at three key figures regarding the smartwatch market:

*IDC forecasts.

IDC believes that one product -- the Apple (AAPL 1.14%) Watch -- will set the market on fire and convince mainstream consumers that smartwatches are actually "cool".

According to IDC's estimates, shipments of non-Apple devices must rise 138% annually to account for the remaining 38% of the market. That's optimistic but achievable -- smartwatch shipments rose 121% annually last year, according to Strategy Analytics and IDC.

Samsung Gear smartwatches. Source: Samsung

As for cheaper fitness bands, the outlook is mixed. NPD analysts believe that U.S. sales of the devices will peak at 32 million devices next year. However, Generator Research offers investors a clearer forecast of the three main categories of wearables -- activity trackers/fitness bands, sports performance devices, and smartwatches:

Source: Generator Research.

The takeaway here is that the cheap activity trackers market, including products from Fitbit and Jawbone, could be cannibalized by cheaper sports performance trackers and smartwatches.

What the valuations tell us
Based on those numbers, no one expects wearables to achieve smartphone-like sales ($300 billion in 2014) by 2020. Yet the media hype about smartwatches certainly makes them sound like a smartphone-like innovation.

To gain a clearer understanding of market expectations for smartwatches, we should check how the supply chain players have fared over the past year. Shares of InvenSense (INVN +0.00%), which manufactures motion sensors for the majority of non-Apple smartwatches, have fallen nearly 30% over the past 12 months.

That decline was caused by two main things. First, InvenSense was hit by a barrage of investor lawsuits over allegations that it sold sensors for Apple's iPhone 6 at rock-bottom margins. Second, STMicroelectronics (STM +2.62%) won the critical contract to provide motion sensors for the Apple Watch. However, InvenSense's decline brings its forward P/E down to 22 -- which is hardly "bubble" territory. For example, Cisco (CSCO +2.56%), which trades at 17 times earnings today, had a P/E ratio of 170 prior to the dot-com bust in 2000.

Apple Watch. Source: Apple

As for Apple and Samsung, smartwatches still only account for small percentages of their top and bottom lines, so their stock valuations are much less useful for gauging the "bubbliness" of the market.

However, Fitbit's recent IPO filing offers investors a glimpse of a pure-play fitness band maker for the first time, and the numbers are impressive. Revenue rose 144% year-over-year last quarter and is on track to top $1 billion this year. Paid active users rose from 600,000 in 2012 to 9.5 million, and devices sold soared 142% to 10.9 million. However, the aforementioned cannibalization of the fitness tracker market could cause that growth to grind to a halt.

Fitbit's valuations won't be known until the offering is priced, but investors should watch this IPO's performance to see if investors have unrealistic expectations regarding the wearables market.

The key takeaways
In my opinion, the wearable market hasn't entered a "bubble phase" yet. Expectations are certainly high, but no one really expects companies to sell as many smartwatches as smartphones or tablets in the near future.

Nonetheless, the wearables market is highly dependent on the success of the Apple Watch. If Apple fails to generate enough mainstream interest in smartwatches, bullish forecasts for the market might have to be revised.

Just as the smartphone market is now split among a few major companies with everyone else squeezed into single-digit market shares, the same might occur with smartwatches. When that happens, smaller start-ups focused solely on wearable devices could be swept away.