Are ETFs Causing an Emerging Markets Bubble?

An interesting question posed by the Wall Street Journal, but I believe a misdirected one. Central bank policies are creating bubbles; ETFs are simply the mechanisms for transferring of said dollars – they are not the cause of all the excess dollars.

Before we get to the main WSJ piece, data from Asia is lifting spirits (and futures) although I noticed in the 4 PM hour yesterday, S&P futures were already up 3.5 points… did that “urgent buyer” who really needed to get into the stock market not have time to buy during the 6.5 hours of normal market hours? ;) So we will definitely be seeing our move to S&P 1100 first thing this morning and it’s game on. China, as always, had “positive” economic news (do they ever disappoint?) and even Japan pitched in… all the more good news to punish the US peso. And when the US dollar goes down… everything else on the globe must go up.

In Japan, September’s 10.5 percent increase for the country’s machinery orders, an indicator of business investment in three to six months, beat economist predictions for a 4.1 percent increase. The increase, more than twice the pace forecast by economists, was driven largely by bookings from service firms for computers and communications. Even after seven months of increasing industrial production, about a third of the country’s factories are still sitting idle. (should sound familiar to American readers, as about 1/3rd of US capacity also sits idle – just don’t call us Japan)

The Chinese statistics bureau reported that industrial production jumped 16.1 percent from a year earlier and retail sales gained 16.2 percent. (yawn – please take your salt when viewing Chinese data)

A bit more interesting was the continued reduction in loan growth, from superhuman levels seen in the first half of 2009.

China’s Shanghai Composite Index lost 0.1 percent, as a slowdown in the nation’s lending growth dragged banks and developers lower. Domestic banks extended 253 billion yuan ($37 billion) of new local-currency loans in October, the People’s Bank of China said. That compares with 516.7 billion yuan in September and a median projection of 370 billion yuan.

Let’s turn back to the ETF story….along with computer dominated trading I believe the emergence of ETFs have completely changed the market over the past 5 years. Often in our current markets, most stocks in a sector generally move based on whether they are part of a popular ETF rather than on their own fundamental merit. And they almost always move together in complete lockstep – if housing is the flavor of the day, buying of XHB ETF will drive up all the housing stocks – regardless of individual metrics; or vice versa.

U.S. investors have pumped roughly $26 billion into emerging-markets funds so far this year. Of that, $15 billion came in through exchange-traded funds — portfolios that hold every stock in a market benchmark with utterly no regard to price.

Several hedge-fund managers and other active stockpickers have told me that this “mindless money” is distorting valuations and pumping up a potentially monstrous bubble. At first blush, it is hard to imagine that they are wrong. As money pours into the ETFs, they must mechanically match their holdings to those in the emerging-market indexes. That forced buying drives up stock prices, attracting still more new money into the ETFs, spiraling stock prices even higher.

Even Gus Sauter, chief investment officer at Vanguard Group, one of the world’s largest managers of index funds and ETFs, is concerned. “Obviously it’s the last trade that determines the price of everything,” he says, “and there have been large flows [from ETFs into emerging markets], perhaps leading to a bit of a bubble.”

Consider Brazil. The iShares MSCI Brazil Index ETF (EWZ) has nearly tripled in size over the past 12 months. Now at $10.9 billion in assets, it has vacuumed up $2 billion in new money this year. Fully 38% of the fund is invested in only two firms: oil giant Petrobras and mining company Vale do Rio Doce.

Extrapolate across the US market (and now the globe) and it’s student body left trading. This story is about emerging market ETFs but I’ve been saying since blog inception, it has now infected everything. Combine that existing situation with the more recent “mindless money” the Fed is pouring into every crack, and you are setting the world up for a repeat of NASDAQ 1999. Only global in nature.

So I suppose one must dance until the music stops, just as one did in 1999. Just make sure to be dancing near the emergency exit door, because when lemmings all rush out at once – a lot of trampling tends to happen. And please don’t swig too much Kool Aid or you might start believing in the “miracle”. Until then? Look in the sky! It’s a bird, it’s a helicopter, no it’s Ben Bernanke! Greenspan 2.0 – faster, bigger, smarter, able to print money at 18x the rate. Able to inflate asset values in a single bound! Our “hero”.

emphasis added

About Mark Hanna 543 Articles

Affiliation: Hanna Capital, LLC

Mark Hanna is President and Owner of Hanna Capital, LLC, a registered investment advisory firm. Mark has been a follower of markets since the late 80s, with a focus on individual equities since the mid 90s. He has been a well known commentator in the financial blogosphere for the past 5 years, following a career in corpoporate finance and accounting. Mark attended the University of Michigan where he graduated with a degree in Economics.

As an avid reader, Market Montage is the personal blogging site for Mark to share his views on economics, markets, and the like. Occasional cynicism and wit shall be deployed in his postings.

Follow Mark on Twitter @fundmyfund.

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