How Long Will Stock Market Exuberance Last? These 3 ETFs May Tell You

Includes: EWX, TLT, XLU
by: Gary Gordon

According to EPFR Global, money poured into stock funds at a faster pace over the last week than at any time since September of 2007. For those who may not immediately recognize the date as particularly significant, October 2007 kicked off one of the most volatile and bone-jarring bear markets in U.S. history.

By no means do I think that January 2013 marks the beginning of another collapse of the financial system. In fact, there are clear advantages for risk-takers in 2013 versus September 2007. A 7% earnings yield for S&P 500 stocks today is presumably quite favorable when compared to sub-2% on 10-year treasuries. Corporate balance sheets have been fortified. And home prices are slowly rising rather than rapidly declining.

Nevertheless, retail investors are notoriously late to stock parties. It follows that their equity fund commitment is worthy of monitoring, especially at a time when stocks sit near five-year peaks.

Fund flow is only one indicator to consider ... and a contrarian one at that. There are also a number of ETFs that may be employed to identify investor behavior.

Here are three ETFs that I am tracking:

1. iShares 20+ Year Treasury Bond (NYSEARCA:TLT). This long-term treasury bond proxy has reflected strong demand for a “risk-off” asset. And for the better part of the last three years, fund flows into bond funds have been vibrant.

Right now, investors may be reevaluating whether or not Treasury Bond ETFs have anything left - either as a safe haven, income producer or capital appreciator. For instance, TLT has dropped further below its 200-day moving average than at any point since November 2010. The last time that happened, the S&P 500 gained roughly 13% in the six months that followed.

If TLT recovers its trendline soon, the potential for significant equity upside might be capped. If TLT continues to drift lower, it would likely be indicative of exuberance for “risk-on” investing to continue.

2. SPDR S&P Emerging Market Small Cap (NYSEARCA:EWX). When investors have been afraid of stock assets during the last five years, they have jumped into treasuries. When they’ve been enticed to take a modest amount of risk, they’ve chosen domestic large-caps that pay dividends.

Yet if we review the last 15 years, we find that “risk-on” investing meant choosing small company stocks from the fastest growing economies worldwide. And with China’s economy turning a corner in the fourth quarter of 2012, small cap emergers via EWX have celebrated in phenomenal fashion.

It should be noted, though, EWX is flashing severely “overbought” warning signals. The last three times that EWX experienced Relative Strength Index (RSI) readings at these levels, the asset went on to register losses of roughly -17%, -33% and -14%, respectively. A correction may or may not occur here, but bullish investors should probably wait for a 7%-8% pullback before entering at this stage.

3. SPDR Select Utilities (NYSEARCA:XLU). For the last three years, it has been a relatively pain-free ride higher. Still, the recent declines from 52-week highs has a number of folks warning that the safer haven stock segment is “overvalued.”

Maybe so. However, the more important issue here would be to monitor whether XLU can stay near its 200-day trendline. If it falls dramatically lower, that might be an early indication that investors fear a spike in interest rates. If XLU moves dramatically higher, that might be an indication of indiscriminate enthusiasm.

Many investors in utility stocks select the non-cyclical segment to avoid the rocky road. They prefer a smooth ride higher. Hugging the long-term trend would be a positive for these markets, whereas a dramatic swing in utilities might be a warning shot across the stock bow.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.