Think back to earlier this year. At the time, the market was convinced Trump was about to usher in a new wave of free market nirvana. Hedge fund managers piled into small cap equity long positions, confident the pro-growth policies would fuel a massive outperformance for the Russell 2000 index. Here is a chart I ran in my piece “The reality is something in between” which shows the extent of the small cap run:
When someone suggested small caps were overbought and prone to disappoint, they were labeled a Luddite who didn’t understand the true extent of Trump’s trans-formative policies. It was a one way freight train that seemed to have no end.
Yet it did end. Not in a big bang, but in a quiet abandonment of the trade. Hedge fund managers might move in herds, but they don’t sit in losing trades indefinitely.
And this is the problem with today’s market. I say problem, but I really shouldn’t use that word. It’s more the reality of today’s market.
With so many shrewd managers chasing limited alpha, combined with the near instantaneous spreading of information, markets almost immediately fully price good ideas. A common cycle plays out like this; there is a new piece of information that requires the market to reprice. The smartest, quickest managers put on the position. Markets quickly move to the new level, and at this point, slower less nimble managers start chasing, causing the price to develop a reflexive quality. With the smartest managers touting their position, and the price action affirming their view, more and more money flows into the idea. Until eventually its price reaches a level that cannot be fundamentally justified, and the inevitable disappointment settles in. I like to refer to these cycles as a series of rolling mini-bubbles.
Let’s look at the recent action in the Russell 2000 trade to get an idea of the phenomenon.
After the Trump win, speculators put on a record long position. As the trade became crowded and pushed too far, the price action stopped rewarding longs. Eventually, the specs sold out their long positions and actually went to net short!
And what do you think they put their money into? Well, I would argue the mini-bubble in the Trump-small-cap-phoria morphed into a FANG-polooza (with a little NVDA and TSLA thrown in for good measure).
Here is the same chart with the Russell 2000 replaced with the ratio of the Russell 2000 and the Nasdaq 100:
Why does this matter? Well, Friday we had the sell off the bears has been pining for. And the Nasdaq 100 chart pattern experienced a serious hiccup.
That sure looks ugly. And in fact, it was scary enough that on Friday afternoon, I saw predictions of a 1987 style crash for Monday.
Except, what do you think happened to the Russell?
Huh? It’s up? What’s that about?
As ugly as the Nasdaq looked on Friday, it didn’t reflect a systemic collapse in equities, but the shaking out of yet another hedge fund induced mini-bubble.
I have seen this scenario play over time and time again. The trades the hedge funds are most enthusiastic about, are the very ones you should avoid the most.
I don’t know if the Nasdaq shakeout is finished, or just started. I do know the optimism surrounding FANG (along with NVDA and TSLA) has taken bubble like qualities. And you might think this statement flies in the face of my belief there is no general bubble in equities. But I hold to this assertion. This Nasdaq infatuation is just another episode in the series of rolling mini-bubbles, and just like the small-cap-Trump trade of earlier in the year, it will be quickly unwound and forgotten. Sure the nimble trader might be able to make some decent money shorting Nasdaq, but it is not the start of some epic equity bear market. Don’t forget, when the small cap trade went south, there were the same predictions of doom.
Instead of focusing on what the hedge funds are buying or selling today, think about what is cheap and might be the object of their obsession tomorrow. Trust me, as sure as an empty cocktail glass in Lindsay Lohan’s hand is followed by a full one, there will be another mini-bubble in next “great” hedge fund idea…