Bubbles are hard to see when they are inflating.
It’s also hard to see when they pop.
But that doesn’t mean they don’t exist.
In notes over the past few days, Julian Emanuel and the quantitative strategy team UBS outlined 3 major trades in the market right now that seem to look a lot like bubbles: long US healthcare, short US energy, and a bet against emerging markets.
This sort of analysis is important, said Emanuel, because bubbles can devastate investors.
Here’s Emanuel in his note Wednesday:
“Bubbles are unique. Once identified, they often inflate to irrational levels — Tulips increasing 20x in three months at the peak in 1637, Nasdaq rising 100% from October 1999 to March 2000 after doubling in the prior year. So while US Energy, EM, and US Health Care, could be bubbles which have already begun to ‘leak’ by way of performance reversion in recent months, there is both sufficient air remaining which could subsequently burst, or alternatively, given valuation and earnings dynamics not yet at historic extremes, could result in further ‘inflation’ despite crowded positioning.
The UBS team used three metrics in order to evaluate how “crowded” different trades are.
- How many of the over 37,000 large, institutional funds are part of the theme.
- How correlated prices in a certain theme are. According to UBS this is a faster way of tracking large investor positioning than waiting for disclosures.
- Sell-side analyst sentiment, basically is there an incredibly high number of analysts with either a buy or sell rating for a theme.
“From a fundamental perspective, we would agree that heading into 2016, underweight energy and overweight healthcare appeared to be the two most crowded trades among US investors, albeit for varying reasons,” said the note.
For healthcare, UBS said the crowding came as healthcare proved to be one of the few sectors that had the ability to raise prices, which led to strong profit growth and investor enthusiasm.
But UBS said this may be coming to an end as the political process has drawn scrutiny to “potential predatory pricing tactics in the pharma/biotech spaces.”
On the other end, the amount of short position in the energy sector seems to have reached a breaking point.
“Given the collapse in oil prices over the past two years, and a significant amount of high-yield debt issuance in the energy space, the energy sector has been, unsurprisingly, the most ‘crowded’ short among US investors. However, the potential for oil-price stabilisation plus substantial short covering, or an improvement in commodity-related sentiment, could cause this trade to unwind rather quickly, in our view.”
So with a possible bottom for oil found, there is a good chance that the sector could revert to the mean quickly.
The third and final “bubble” is in betting against emerging markets as a way to bet on continued dollar strength. All of these trades, according to the UBS quant team, have reached a possible inflection point.
“The Fed’s recent dovish rhetoric, and the selloff in the US dollar over the past several weeks, has likely provided the catalyst for DM equities to underperform their EM peers — a view that our EM equity strategist shares,” said the quant team’s note.
“In other words, our crowding indicator and fundamental evidence suggest that arguably one of the most popular macro trades (DMs over EMs) may have begun to unwind.”