3 Reasons Irrational Enthusiasm For U.S. Stock ETFs Will Continue

Includes: ITA, PJP, RTH, SDY, VIG, XLV
by: Gary Gordon

The city of Detroit just filed for the largest municipal bankruptcy in U.S. history. Crude oil is pushing $110 per barrel. Microsoft (NASDAQ:MSFT), eBay (NASDAQ:EBAY), Intel (NASDAQ:INTC) and Google (NASDAQ:GOOG) severely disappointed in their Q2 earnings reports. Housing starts dropped to its slowest pace in 10 months. And while it may appear unlikely to market watchers, the Fed may still taper its bond purchasing program earlier than anticipated.

Less money for retirees, less consumption due to the gas pump, lower sales by bellwether corporations, fewer homes being constructed and less borrowing due to elevated interest rates. Is this the stuff that stock market rallies thrive upon? Apparently so.

Yet the remarkable run-up may be running out of time. One of Warren Buffett’s favorite indicators of over-the-moon stock prices is the ratio of total market capitalization to gross domestic product (GDP). According to CNBC, the net ratio stands at 118 percent. Previous moments in history when the ratio exceeded 100 percent include 1999 and 2007 — right before humongous stock bears mauled the S&P 500 and slashed its value in half.

Nevertheless, this Fed-fueled uptrend has defied analyst criticism and brushed aside guru bearishness for years. Famous doom-n-gloomers from Roubini to Rosenberg have found themselves waving the white flag. Meanwhile, perma-bulls are expecting the S&P 500 to gain at least another 10%-15% by year’s end.

Personally, I am playing it relatively safe with my client allocation to equities. That said, there are at least 3 solid reasons why irrational enthusiasm may ”win out” for a while longer.

1. Underperforming Institutional Dollars. Hedge funds and most institutional advisers have struggled to keep pace with U.S. stocks; any effort to diversify or hedge with competing assets (e.g., commodities, currencies, foreign stocks, foreign bonds, domestic bonds, etc.) have only dragged on portfolio performance. It follows that in a “what-have-you-done-for-me-lately” investing arena, the pressure to perform has resulted in limited diversification and greater ownership of U.S. equities.

2. Political Necessity. Due to the Federal Reserve’s manipulation of interest rates, corporations have been able to restructure debt and buy back shares of stock; consumers have been able to purchase big ticket items like residences and automobiles. Meanwhile, the subsequent wealth effect associated with rising home prices and rising 401k values is something that the President’s political party wants to see continue. It follows that Fed flexibility on tightening does not mesh with the reality that the President will choose a stimulus-favoring replacement in January of 2014. In that manner, the central bank would likely maintain the status quo through the mid-term elections in November of 2014, rather than do anything to upset the apple cart.

3. Global Monetary Stability. Many have heard of the “Butterfly Effect.” Simply put, when a butterfly flaps its wings in China, the breeze can be felt on a street corner in Manhattan. If there’s one thing that the recent tapering debate demonstrated to members of the Federal Open Market Committee (FOMC) is that the U.S. cannot act independently of the rest of the globe. If the U.S. moves toward tightening, weak eurozone countries (e.g., Spain, Italy, Portugal, etc.) will see the rates on their sovereign debt reach unsustainable levels. Unless the eurozone makes more significant progress in containing the debt debacle, the U.S. risks stoking the fires of debt contagion. In other words, unrestrained stimulus will be around for longer than many people think — and that means irrational exuberance may be around for longer than the naysayers care to accept.

Again, there are scores of signs of an overvalued, overextended stock market. And yet, there are plenty of signs that the Fed-inspired stock bull will carry on… however wayward the reasoning.

For my part, I continue to stick with ETFs that exhibit less rate sensitivity and strong defensive attributes. I still hold large positions in vehicles like SPDR Health Care Select Sector (NYSEARCA:XLV), PowerShares Pharmaceuticals (NYSEARCA:PJP) and Market Vectors Retail (NYSEARCA:RTH). I believe in defensive ETFs like iShares DJ Aerospace & Defense (NYSEARCA:ITA) and view Boeing (NYSE:BA) uncertainty as opportunity. Dividend growth via Vanguard Dividend Growth (NYSEARCA:VIG) or an allegiance to dividend aristocrats via SPDR S&P Dividend (NYSEARCA:SDY) is also desirable; these ETFs are likely to be less rate sensitive than higher-yielding dividend funds.

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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.