"Where Are The Bubbles?" - All In One Chart

As has become increasingly obvious to many, unconventional central bank policies have resulted in an unprecedented level of crowding – a "herd mentality" to trade positioning on the basis of a similar theme – throughout global equity markets. UBS quant team guages the "barometric pressure of developing investment bubbles" across various factors and looks for the inflection points with the dollar, oil, and politics as the main catalysts.

Despite the possession of the most rigorous and innovative analytical tools, in former Fed Chair Ben Bernanke's words, "Identifying a bubble in progress is intrinsically difficult."

Bubbles throughout history have unfolded uniquely.

Once identified, bubbles can inflate well beyond the naysayers and even the most wild-eyed optimists' expectations. Fed Chair Greenspan's popularization of the phrase "irrational exuberance" occurred in the midst of Nasdaq's historic climb, where prices rallied a further 500% to the peak in March 2000, only to fall 80% thereafter (Figure 3). Ironically, Bernanke's speech lamenting the difficulty in identifying bubbles came days after the 2000-02 technology led Bear Market's historic capitulation low.

But UBS' quantitative equity research team cites unprecedented capital market conditions, quantitative easing and divergence in monetary policies which have led to large flows of cheap money into equity markets globally as a reason that thematic investment bubbles have inflated, increasing the prevalence and risk of crowding – a global "herd mentality" to trade positioning.

With fundamental input from UBS' regional strategists, the quant team introduces its "toolkit" for gauging the barometric pressure of developing investment bubbles (in both overweight and underweight themes) using institutional holdings, return correlations within peer groups and sell-side sentiment. The results identify a number of potential global equity market bubbles:

Are underweight US Energy and EM and overweight US Healthcare truly bubbles? Positioning and sentiment dynamics that would indicate that US Energy is a bubble in negativity while US Healthcare is a more traditionally "bullish bubble."

In terms of institutional holdings, return correlations within peer groups and sellside sentiment, quantitatively this would appear to be the case, in varying degree and size. And if indeed these three are bubbles, they likely have begun to deflate in recent months.

Catalysts: Dollar, Oil Politics

With identification of bubbles and timing of bubble deflation ostensibly as much art as science, what could cause the potential underweight US Energy and EM bubbles and the overweight Health Care bubble to pop?

Given the extremely strong correlation of oil prices and the US dollar to US Energy and EM share performance over the last two years (Figures 8 and 9) a stabilization and rally in Oil (UBS forecasts $40 WTI for 2016) or a continued decline in the US Dollar (UBS forecasts Euro/$ of 1.16 by year end 2016) – both of which have been supportive over the past month – could catalyze further outperformance in these areas over the coming months, particularly if oil producers agree to cutbacks or Fed rhetoric continues to guide markets in a dovish manner.

On Health Care, while earnings trends would appear to be relatively intact, the threat of political action once Washington changes regimes in 2017 could continue to pressure valuation, as has been the case since the first "political broadside" against "excessive" drug pricing went viral in September 2015 and as threats to repeal Obamacare have magnified.

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 regulatory regime has resulted in lower mean valuation for Financials.

The option markets provide a good risk to reward profile for implementation of "Crowded trade unwind positions"