A Series Of Rolling Mini-Bubbles

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!

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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