These Three Popular Trades Might Be Ready to Burst

UBS sounds a warning on health care, energy, and emerging market positions.

How to Make Money in Volatile Markets

Former Federal Reserve Chair Ben Bernanke once said, "Identifying a bubble in progress is intrinsically difficult." That hasn't stopped people from trying.

UBS Group AG strategists led by Julian Emanuel have taken a look at three popular trades, which they refer to in a new note as potential bubbles, at least in the sense that investors have flocked to them. Those crowded trades include going long on U.S. health care and shorting U.S. energy and emerging markets. The strategists argue that these trades have shown signs of deflating in recent weeks, causing some concern as to whether they may have run their course.

That sound you hear coming from those bubbly positions, it turns out, may indeed be the hiss of escaping air:

UBS

"In terms of institutional holdings, return correlations within peer groups and sell-side sentiment, quantitatively this would appear to be the case, in varying degree and size," the note said. "And if indeed these three are bubbles, they likely have begun to deflate in recent months though clearly there is additional room for greater performance reversion in the months ahead based on the return dispersion that has accrued in the four years since the end of the last market correction [In October of 2011], comparable to the current correction."

The team concluded that, while by some metrics these trades look to be at an inflection point, the bubbles could continue to get bigger or slowly deflate, rather than popping.

A number of elements could significantly alter prospects here. The price of oil will certainly have an impact on U.S. energy sector earnings, and strength in the U.S. dollar may change the outlook for emerging markets. And a recent note from Morgan Stanley's agriculture team was skeptical as to just how crowded the short oil trade is—by extension, bringing into question UBS's analysis of the energy sector: 

UBS

"In our conversations with investors and producers in recent weeks, we’ve been surprised at the level of bullish sentiment that persists," the Morgan Stanley note stated. "Equally surprising is the view that the market is overly negative and short, and thus being bullish is contrarian. That’s not what we see. Positioning does not support this bullish contrarian view, and implied volatility for deferred calls on Brent has risen more than puts."

Finally, when it comes to health care, Washington will play an outsized role, given the impending U.S. presidential election and how a Republican victory and a friendly Congress could work to repeal Obamacare in 2017.

Said the UBS strategists: "The persistence of political pressure and the possibility of a legislative assault on earnings in 2017 and 2018 could catalyze investors to re-rate health care stocks in a manner similar to that which the post GFC (global financial crisis) regulatory regime has resulted in lower mean valuation for Financials." 

Before it's here, it's on the Bloomberg Terminal. LEARN MORE