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Without a doubt there has been significant concern about asset price bubbles. Even though there still is not a good working definition of a bubble. Many define bubbles as booms that go bust, but that only means that we will never know we are in a bubble until after the fact. Clearly, there has been vivid descriptions of some famous cases including the technology bubble in the US; nevertheless, a closely look at history suggests there have been many booms that have not been busts. While the chance of a boom leading to a bust is higher than a unconditional forecast, the number and frequency of busts is not so high as to say confidently that all large price moves will turn into crashes.

I was having a discussion with friends for where the SPX will end over the next three and six months as well as what could be the ending value for the year. The predictions were all over the map with a mix of investors saying the market will be either higher or lower. I also had some that said it would be both, first higher then lower, and others suggesting the first leg will be lower only to then go higher again.

The latest Credit Suisse hedge fund survey for 2017 provides a detailed review of where there is the most investor demand for hedge fund strategies. Number one is global macro based on a desire to have greater portfolio diversification. This appetite is followed by fixed income arbitrage. The swing in demand shows a movement away from long-short equity and a movement to credit and sector specific strategies.

Style returns were all positive for February with the largest gain for the large cap US SPX index. International stocks lagged given the increase in the value of the dollar. Small and mid-cap indices did not gain as much in February after stronger movements over the last few months since the US election.

Quants focus on data and numbers. Forget any story or narrative and show me the data. Yet, a narrative often drives markets. Investors have to be aware of the current narratives that are in the market place because it can provide either a headwind or tailwind for market moves. The narrative can be consistent with the underlying data or it can be in conflict. The narrative can be driven by good economics or it can be driven by theories that have been popular in the past but have been debunked. Financial journalists look story that fit the facts nicely. Consequently, it is important to read the news to appreciate the current market narrative or storyline.

What seemed to be a slight rest at the beginning of the year has turned again to a strong equity bull market. The reflation trade is back as signaled by equity index behavior. Bonds also suggest a reflation trade given the recent talk by Fed Chairman Yellen and other officials concerning the likelihood of Fed action in March. While not a rout, bonds are also signaling a growth trade.

All hedge fund strategies gained for February with especially strong performance for systematic CTA’s and fundamental growth strategies as measured by the HFR indices. Managed futures showed gains because both equities and fixed income markets trended higher for the month. The fundamental growth strategy seemed to be positioned to take advantage of the global reflation trade. Other winners included market directional and distressed restructuring strategies.

The self-fulfilling prophecy is, in the beginning, a false definition of the situation evoking a new behavior which makes the originally false conception come true. The specious validity of the self-fulfilling prophecy perpetuates a reign of error. For the prophet will cite the actual course of events as proof that he was right from the very beginning.

– Robert K. Merton from Raji Sethi blog

Robert K Merton wrote about this issue in 1948 in the Antioch Review

“If men define situations as real, they are real in their consequences”

– W.I. Thomas

The global macro manager is always worried about a few key issues. Where will country and global growth come from? What will be the flow of liquidity and credit to markets? What will be the desire by investors for risk-taking? The answers to these questions will describe the drivers of future asset returns.

Managed futures strategies generally showed performance gains in February based on strong equity market return trends and the the positive gains in fixed income markets. The dollar also started to again trend up while commodities markets were more mixed. It is notable that there was a strong gap between traditional trend-followers and short-term traders whose index was down almost 2% for the month.

If I invested based on political rhetoric and news, I would be moving to a safe asset and expect stocks to decline. The uncertainty concerning policy and the animus between political parties and countries would suggest an environment that would not be suitable for the long-term optimism that is needed to see equities march higher. If I read just the financial papers and economic data, I would paint a more optimistic picture with consumer and business surveys both showing a positive environment. If I were a focused policy wonk, I would have a mixed view on market prices with the potential for stimulative policies but still a policy environment where details and specifics are scarce. It is hard to see these differences continuing. As politics, economics, and policy come into focus, there will be a strong reaction in price. Unfortunately, predicting when this alignment will occur is very difficult.

There is still concern about the potential for large moves in bonds during the next three months. The latest rolling yield changes shows a calming after the large moves late last year. Nevertheless, uncertainty on policy, growth, and the equity markets may all impact Treasury yields, the “safe” asset. If safe means limited moves in yield, investors may be in for a surprise. A flight to safety can easily take the 10-year below 2% while a pick-up in inflation or growth can lead to yields pushing closer to 3%.

Markets have been known to move to price extreme which have often been referred to as bubbles. The best know of these bubbles have been noted to lead to large market dislocations in both financial markets and the real economy. The “dot com” and housing bubble are the best known most recent examples, but unfortunately, there has not been much agreement on what are identifiable characteristics or the cause of these bubbles. While there can be agreement that bubbles are related to positive feedback loops, there is little work on a method for filtering data through some general model that will define a bubble.