I’ll be the first to admit that we’re not first to press with that storyline. However, one of the lessons we learned (the hard way) during the recent credit crunch is that analysts’ forecasts of earnings estimates can be quite unreliable, especially at inflexion points. For instance, last year consensus estimates for firms in the Financial Select Sector SPDR (XLF) were rising through mid-summer, well after the sub-prime story started unraveling.

So this time around we wanted to wait for actual results, as opposed to relying on analysts’ predictions, to mark a turning point for Financials. Now with about 80% of S&P 500 firms having reported Q1 2008 earnings, it looks as if we can make that claim with some confidence: aggregate profits of firms in XLF will be about $12 billion, down a whopping 79% versus Q1 2007, but nonetheless a big improvement over the previous quarter, Q4 2007, which saw aggregate losses of some $21 billion (Figure 1).

So-called Socially Responsible Investing is a big trend on Wall Street these days. ETF investors can get in on the gambit with the iShares KLD Select Social Fund (KLD). The fund which the index tracks selects stocks from the Russell 1000 (an index of large and mid-cap domestic stocks) screened based on non-economic criteria that KLD considers socially desirable, such as workplace diversity, product quality & safety record, environmental friendliness, etc. The index also excludes all tobacco-related stocks, but does include some holdings that might surprise you, such as Exxon Mobile (XOM).

That’s all fine. However, the problem is that socially responsible investing probably doesn’t work. I have been unable to find any convincing evidence which shows that SRI benefits anyone, either by delivering superior investment returns, or by encouraging companies to “do the right thing” in order to be included.

S&P 500 EPS earnings fell 5.6% in Q3 2007 and current consensus estimates suggest Q4 is likely to be down double-digits (Figure 1). For the year as a whole S&P 500 firms will be lucky to eek out a gain at all.

But of course the real question is of course what happens to earnings this year. Current estimates envision a 15% gain, but this could prove wildly optimistic. It would be without precedent for S&P 500 earnings to decline two consecutive quarters (as they did in Q3-Q4) and not precipitate a more prolonged profits recession.

There is a growing sense that the basic provisions for human life—food, water and energy—will become increasingly dear in growing world. Competition for scarce resources is compounded not only by world population growth but also by the masses of newly-minted middle class consumers.

Add to this the belief by many that traditional resources are running out and new, more environmentally friendly resources must be found, and you have the makings of an incredible bull market in the basic necessities. So, as surely as night follows day, fund companies have rolled out products designed to give investors exposure to these hot markets (click all charts to enlarge):

“Demographics is destiny,” is a phrase that is overused and abused. Demographics isn’t destiny, but it does play a major role in the rise and fall of civilizations, which in turn may influence where you choose to invest. So we thought it would be interesting to see how the populations represented by some of the international ETFs we follow stack up against the U.S. in terms of demographics.

Using estimates from the U.S. Census Bureau, we calculated the expected population growth over the next 25 years—roughly a generation—as well as the percentage of the population 65 years of age or older, both now and in 2032. For single country ETFs this was easy; for the regional funds we used a weighted average of the constituent countries.

Investors have become giddy over Chinese stocks, reminiscent of their collective enthusiasm for Tech stocks famously crystallized by Alan Greenspan as “irrational exuberance.” Then as now investors seem to be convinced that the old measures of value simply no longer apply.

Back then the justification was that the “new economy” heralded the start of an era of unprecedented growth, particularly for Tech stocks, and so earnings no longer really mattered, at least for the foreseeable future. Today we constantly hear about how the Chinese economy—and virtually everybody else for that matter—won’t be affected by a potential slowdown in U.S. economic growth.

As new fundamentally-weighted ETFs come to market and those already listed continue to grow in assets, the debate about the merits of fundamental indexing rages on. Don’t worry; this isn’t about rehashing the arguments for or against.

Instead, let’s suppose you’re sold on the concept, or at least convinced enough that you want to create a global investment portfolio using these new funds. Luckily, PowerShares now offers six fundamentally-weighted funds that allow you to cover most of the world:

It’s no surprise to anyone with even a passing interest in international investing that foreign stocks have been doing much better than their U.S. counterparts, and emerging markets in particular have been on fire. The iShares MSCI EAFE index fund (EFA) of developed-market stocks is up about 12% year-to-date, while the iShares MSCI Emerging Markets index fund (EEM) is up around 30%.

An article posted here yesterday from Bespoke Investment Group noted the low expectations for S&P 500 earnings growth in Q3, but also correctly pointed out that expectations going into earnings season have a history of being low-balled and may well prove conservative in the end. However things play out for the index as a whole, the earnings picture at the sector level is quite varied, and some expectations may surprise you.

The graph below shows the expected earnings growth for each of the nine Select Sector SPDRs, both as an annual percentage rate as well as each sector’s dollar contribution to overall index earnings growth, to help you visualize the relative magnitude of each. We calculated these figures using consensus EPS estimates for each index constituent. Overall, S&P 500 earnings are expected to increase by about $8.1 billion, or 4.1%, in Q3 versus the same quarter last year.

The past few weeks have seen a wild ride in financial markets, as investors worried that the mess in sub prime mortgages would lead to an overall credit crunch and, eventually, a recession. Don’t worry—we’re not going to debate that issue here. This article is about bargain hunting.

Although stocks have recovered some of their losses since the market hit a recent low on August 15th, all but two of the 58 ETFs we cover—the iShares FTSE/Xinhua China 25 (FXI) and Hong Kong (EWH) funds—are still lower than they were in mid-July when the correction began. And as with any market panic, sometimes the baby gets thrown out with the bath water, creating opportunities down the road. What follows is a discussion of three ETFs we think are bargains, one from each fund category: Broad Market, Sector, and International.

Actual results are strong. With three-quarters of all S&P Financial firms having reported Q2 results, including virtually all banks and diversified financial firms (leaving mainly insurance companies and real estate investment trusts), sector earnings look like they will be up a decent 7.8% versus Q2 of last year. But what’s impressive is that expectations were for just 2.8% growth at the start of earnings season. That five percentage point difference is the largest upside surprise of any sector, and it is by far the largest contributor to the “strength in S&P 500 earnings” we often hear about in the press.

XLF is cheap. If our analysis is correct that on the whole fundamentals in the sector are improving, not deteriorating, then Financials appears compellingly cheap. XLF currently trades at 11.2x 2007E EPS—with several of the largest, most stable institutions trading at single digit price-to-earnings multiples—compared with 15.4x for the S&P 500 (Figure 2). XLF also has a dividend yield of 2.9% which, if not something to write home about, still compares favorably to the paltry 1.9% yield on the S&P 500.

However, the story in Large Cap stocks is quite different. Despite nearly ubiquitous predictions from Wall Street’s prognosticators that growth stocks would finally start to outperform value stocks after being out of favor for more than half a decade, so far at least that hasn’t happened.
One reason could be what I refer to as a “dirty little secret:” namely, stocks in the iShares S&P 500 Growth fund (IVW) don’t actually grow earnings appreciably faster than stocks in the iShares S&P 500 Value fund (IVE)—they’re just more expensive!

Specifically, between 2002-07E, stocks in the Growth fund (IVW) have grown earnings at a compound annual growth rate of 14.6%, compared with virtually the same growth rate of 14.5% for stocks in the Value fund (IVE) (Figure 1). And in fact the value stocks fare substantially better than growth stocks if you extend the analysis to include the last recession.

In our analysis of the underlying constituents of the iShares S&P SmallCap 600 Growth (IJT) and Value (IJS) funds we found a startling fact: stocks in the growth fund are now cheaper than stocks in the value fund!

Actually IJT is only cheaper by a fraction in terms of the price-to-earnings ratio (Figure 1), but typically you’d expect value stocks to trade at a noticeable discount to growth stocks, not at a slightly premium. And at any rate most value investors are generally looking for stocks with P/E ratios in the 10-14x range, not the nearly 20x that smallcap value stocks in IJS now fetch.
Oddly enough, this is not the result of the smallcap value stocks outperforming smallcap growth stocks dramatically as is the case with large cap growth and value stocks. In fact, while smallcap value stocks did fare much better during the last recession, over the past five years—an expansionary period—IJT has done slightly better than IJS.

Figure 1 shows the upside surprise—the percentage by which reported earnings beat consensus expectations—in each of the prior eight quarters, illustrating that Q1 2007 results so far are by no means extraordinary. Regardless, the upside surprise no doubt appears more impressive as earnings growth has slowed to the lowest level since Q2 2002.

Admittedly the relentless run-up in stock prices makes us a bit nervous, but we’re not trying to bad mouth earnings. In fact we’ve been anticipating a slowdown for a while and if anything are guilty of being early. Further, we’ve consistently said that any slowdown in earnings growth does not necessarily spell trouble for the market.

Excerpted from Michael Krause's ETF Advisor for April: As well as U.S. markets have performed over the past few years, many foreign markets have done notably better. The iShares MSCI EAFE fund (EFA), which tracks an index of developed-economy stocks widely considered to be the international counterpart for the S&P500, has outperformed handily since 2003, gaining 169% vs. 84% for the S&P500 SPDR (SPY). Meanwhile stocks in the iShares MSCI Emerging Markets fund (EEM) have done even better (Figure 1), leaving many investors wondering if it isn’t time to bring some money home.

Regular readers will know that we still like many emerging markets (EEM as well as some other single country funds) despite their outsized gains, while we think EFA seems fully valued if not slightly expensive versus the S&P 500. Unfortunately, this presents a conundrum for conservative investors who still want international exposure but are looking for more value than they can find in EFA and who’d rather not stomach the volatility of emerging markets.

The S&P 500 consists of five hundred large cap stocks representing roughly 80% of the overall market for publicly-traded U.S. equities. However, the index does not simply consist of the largest 500 companies by market cap. Rather, stocks are selected for inclusion by the S&P Index Committee, whose judgments about which stocks to add and which to exclude constitute de facto active management just as if the committee was a portfolio manager at your average fund company.

The S&P 500 Index Committee maintains guidelines on index membership criteria which go beyond passive observance of market cap levels. Among other things, these guidelines include profitability requirements (i.e., a company actually has to have profits) and “seasoning,” a minimum amount of time in existence as a publicly traded corporation. Collectively, these rules impart a character on the index akin to an investment philosophy that, whatever its merits, is different than if the selection criteria were purely market driven. But what bears even more traits of active management is the fact that these are only guidelines which the S&P Index Committee can and often does disregard.

Consumer Discretionary SPDR (XLY): We’re not bears on the U.S. consumer per se, but earnings estimates for XLY simply appear too optimistic to us, since they are predicated on a big increase in margins to levels never before achieved. Estimates are in free fall, yet XLY has the highest P/E of any sector – higher than even Technology!

Consumer Staples SPDR (XLP): Earnings for companies in XLP are forecast to grow faster than earnings for the S&P 500 this year which may make the sector a good defensive play, but XLP already trades at a premium to the market. Plus, the sector’s Return on Equity has been falling for years, which poses an additional threat to valuations given its high Price-to-Book Value multiple (there is a high correlation between ROE and P/BV, so falling ROE could mean lower P/BV multiples in the future).

A landmark study published in 1986 by Brinson, Hood and Beebower* concluded that even professional money managers were able to add very little value by their selection of individual stocks or attempts at market timing. Rather, the vast majority of variation in returns – 93% in the funds examined by the study – could be explained by asset allocation.

Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but it also complicates the selection process. How do I know which ETFs make the most sense for my portfolio?

Perhaps because ETFs started out being compared to mutual funds, as they grew in number most analysts started evaluating them as mutual funds. Morningstar™, for example, the large mutual fund rating outfit, says in materials on its website, “The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for [mutual] funds.”

Now before you stop reading, all else being equal fees do matter. But rarely if ever is all else equal. Fees for ETFs have already been reduced to such an extent that a difference in costs of a few basis points between funds is likely to be overwhelmed by the difference in performance of the underlying investments, making fees a secondary and far less important consideration.

For example, among several large cap domestic stock ETFs, the S&P 500 SPDR (SPY), with an annual fee of 10 basis points, returned 15.8% in 2006, while the Dow Industrials DIAMONDS (DIA), with an annual fee of 18 basis points, returned 18.9%. The large-cap iShares Russell 1000 (IWB), at 15 basis points, was up 15.4% last year and the NASDAQ-100 Tracking stock (QQQQ), at 20 basis points, gained only 7.1%.