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 U.S. 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 a grain of 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 U.S. market (and now the globe) and its student body left trading. This story is about emerging market ETFs, but I've been saying since the blog's 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".

Comments

[igggy:]

So what do you think will burst this bubble?

Nov 12 12:37 AM

[Michael Clark:]

Actually, it's a misconception that all bubbles are debt-related. Bubbles are price-related. Debt-bubbles are bubbles in debt that can and do affect prices. But price-bubbles exist without debt-bubbles.

Let me give an example. My mother-in-law in the 1960's decided to raise quail in Vietnam. She took her savings out of the bank, built a large quail hutch in her backyard, and raised quail. Soon she was making a very health profit as quail became the rage in Saigon. She watched her profit soar.

She had a reputation for being a shrewd business woman. So when she began raising quail, her neighbors did the same thing. No loans were taken -- this was all based on personal savings, cash, as are most transactions in China.

The price of quail soared to 10 times or more. Soon everyone and their dog was raising quail. Then, with more quail businesses coming on line, and with competition from hundreds of competitors, the price of quail fell back to nothing.

My mother-in-law sold all her quail and tore down the quail-hutch and moved on.

Was the Great Tulip Bubble in the middle ages spurred by credit or simply by price appreciation, connected to fad. Is the current Asian Housing Bubble NOT a bubble because the over-building is occurring largely from saved money, instead of debt -- if, indeed, that is true? The Chinese have loaned a LOT of money, in fact, to developers who are building houses for no one but the speculators who are now hoarding property, imaging a never-ending boom in Asia.

The price bubble is largely a picture of supply and demand, classical capitalism. Too much supply and the price bubble breaks.

In China and Vietnam, developers (with some borrowed money but also with cash) are building house after house after house. The houses remain empty. There is some picture of the housing boom going on forever, with foreigners coming to live in Vietnam and tourists...some picture of a never-ending demand. Most of these houses are luxury houses, selling for $100,000 to $500,000. This is a price bubble. A local newspaper is 28 pages long and has 26 pages of 'houses for sale' adds. Most of the people in Vietnam are buying houses with cash. It is true that they won't lose their house to the bank...but they will watch the house they paid $200,000 for sink back toward zero, unless the mean salaries for Vietnam go up from their current $2000/year average.

A credit bubble is a bubble in available credit -- and this always affects prices. The odd thing is that credit is supposed to have a built-in safeguard. When there is high demand for debt, the interest paid is supposed to go up, balancing the demand. But when the government steps in and destroys the balancing mechanism, then bubbles build that are debt/price bubbles (dot.com, housing, tbond currently, current stock market rally -- i.e., bubbles built with borrowed money).

Price bubbles are less deadly than debt bubbles because price bubbles only hurt the investors when they break -- that is, the don't imperil the banking system unless the banks themselves have been heavy investors in the commodity that is out of balance, vis a vis price.

Debt bubbles are more catastrophic, because they destroy the banking system that loaned the money that is being lost as the bubble pops.

The Fed's role should be to monitor debt-bubbles, and make sure they don't happen -- they can leave pure price bubbles alone. Debt-bubbles are manipulated bubbles outside the province of the 'natural' greed/fear cycles of supply and demand, that eventually balance themselves. Debt-bubbles lead always to depressions.

Margin needs to be reconsidered as a financial tool. Clearly it needs to be limited. Minimum bank reserves also needs to be reconsidered. It is really hard to believe that the Fed was monitoring total debt in the system -- and was thinking about how debt was a kind of mass of matter that, when it became dense enough, would implode the universe and send it involuting back to zero. The Fed are bankers. To bankers, more debt is more money for them.

Also, price-fixing is a crime that makes a price-bubble appear and last for decades. Price-fixing is one of the worst crimes that can occur in a capitalist country, because it is anti-capitalist...and it is very common. (Why compete, when you can share capital from the duped consumer? No one gets hurt. It's all good.)

Nov 12 01:42 AM

[ebworthen:]

ETF's are the new version of individual investor grade CDS 's or "Buy and Hold" funds or the Walkman or the iPod.

They need something to market to bring the money in, they need a gig, they need an acronym.

It's not about the product as much as it is about the marketing, to get the herd moving, to bring the money in and skim the profit and cover the loss and move on.

Remember Fondue? The Pet Rock? Leg Warmers? Lehman Brothers? The Hunt Brothers? Confederate dollars and the French Nobility?

Yeah...like that.

Nov 12 01:50 AM

[Maxe Paul:]

Well you learn something new everyday on here that's for sure.

The Great Vietnamese Quail bubble of the 1960's.

ROFL.

Nov 12 10:06 AM

[John Galt:]

You hit the ultimate nail on the head.

It isn't that housing, emerging market etfs, stock market, alternative energy, oil are bubbles on their own right.

These are symptoms of the cause... the fed handing out free and cheap money and printing it. That new money finds a new home ( the bubble de juir) and there you go.

The whole time people will blame the participants and the people who fueled the bubble, but in reality it was the Fed that made it all ultimately possible.

Abolish the Fed. They have failed at their job and they make things worse than they would have otherwise been.

Nov 12 10:34 AM

[tripleblack:]

With questions like the one posed, its always a good idea to seek out and clearly identify cause and effect...

The ETF's are just a score sheet... A side-effect.

Nov 12 10:37 AM

[LaChic:]

the only etf's i have on my radar to buy only on a pull back are India, Indonesia, and Vietnam.......the rest, thanks but no thanks.

Nov 12 05:32 PM

[TraderMark:]

bingo

people confuse symptoms with disease

all our symptoms come from the same culprit

there is a reason we did not have serial bubbles before Greenspan era. These last 2 chiefs are simply drug dealers in disguise.


On Nov 12 10:34 AM John Galt wrote:

> You hit the ultimate nail on the head.
>
> It isn't that housing, emerging market etfs, stock market, alternative
> energy, oil are bubbles on their own right.
>
> These are symptoms of the cause... the fed handing out free and cheap
> money and printing it. That new money finds a new home ( the bubble
> de juir) and there you go.
>
> The whole time people will blame the participants and the people
> who fueled the bubble, but in reality it was the Fed that made it
> all ultimately possible.
>
> Abolish the Fed. They have failed at their job and they make things
> worse than they would have otherwise been.

Nov 12 05:48 PM

[TraderMark:]

Big fan of Indonesia
just saw Vietnam out, I believe Market Vectors

An Indian small cap will be launched soon, I am interested in that

still like the chinese small cap one as well (HAO)

You should think about Brazil as well, BRF

but they all move together as 1 big carry trade so I am not sure if any of the differentiation matters in this new era of computer trading,


On Nov 12 05:32 PM LaChic wrote:

> the only etf's i have on my radar to buy only on a pull back are
> India, Indonesia, and Vietnam.......the rest, thanks but no thanks.

Nov 12 05:50 PM

[Frankie62:]

I'm concerned about all the ETFs - there are so many and no one double checking their actual holdings. Seeking to mimic a group of stocks is not necessarily as easy as it sounds. Playing ETFs seems more like betting rather than investing. Good luck to all you players.

Nov 13 09:23 AM