Is new ETF to track ETF industry another sign of an ETF bubble?

Burton Malkiel, early influence (along with Eugene Fama) on Vanguard founder and indexing pioneer John Bogle, has been hired to join the investment committee of the Tosoro ETF Industry Index.  This index guides the ETF Industry Exposure & Financial Services ETF (TETF) recently unveiled on June 26^th.

Adding irony to the launch, there appear to be flaws with index construction, not uncommon for ETFs.  The companies in Tier A, which make up 50% of the index and have “direct financial impact” from the ETF industry, are equal-weighted.  That means BlackRock (BLK), with a $71 bil market cap, has the same weight (6.25%) as Wisdom Tree Investments (WETF) with a $1.43 bil market cap.

One dirty little secret of the ETF industry is that there is no such thing as a “passive” index.  Otherwise, why the need to hire an investment committee to decide components and weightings?  The timing of a new ETF is another matter, and almost always a backward look on performance and forward look on what will entice investors.  These are not impartial decisions made by machines, but value judgements made by humans.  Value, as any Austrian economist knows, is always subjective.

The bear crying wolf

A perennially bearish hedge fund manager with an Austrian economics bent recently appeared as a guest on the Tom Woods Show.  Tom Woods opened the discussion with:

What do you say to somebody who says, “The trouble with you Austrian-influenced financial guys is that you’re always bearish, so of course you’re going to be right when things go wrong.  Why should I listen to you now?”

Great question.  Are we Austrians eventually right, but always early?  Is this one “big, fat, ugly bubble” that, when it bursts, will vindicate all of us?  Are we just flat wrong?  Is Austrian Business Cycle Theory (ABCT) out of touch with reality?  Or are we stopped clocks, right twice a day, but miss out on a lot of opportunities the rest of the time?

For the full article by Kevin Duffy, see here.

Where are the ominous headlines?

The momentum stock bubble burst last week, with highflying stocks showing significant declines from their February/March highs:

• brokerage stocks: -10.8% (high set on March 20)
• housing stocks: -9.4% (February 27)
• Internet stocks: -17.1% (March 4)
• biotechnology stocks: -21.1% (February 25)
• Tesla Motors: -20.0% (March 4)
• Netflix: -28.2% (March 4)
• Twitter: -45.4% (December 26)
• 3D Systems: -50.1% (January 3)

Yet a brief scanning of the financial headlines shows little concern:

• MarketWatch.com – “Stocks fall as volume rises, but here’s why not to worry”
• The Wall Street Journal – “Stock-Market Jitters Put Investors at Ease; Recent Turbulence Is Seen as a Healthy Sign”
• CNBC – “Last week’s big selloff ‘probably over': Pro”
• MarketWatch.com – “Don’t let these stock market gyrations scare you; It’s likely that we’ve seen the end of recent declines”

The common theme among pundits is that the momentum bust is isolated, contained, healthy, and even predictable.  CNBC quoted Jonathan Golub, chief U.S. market strategist at RBC Capital:

“I think the selloff is probably over.  If you look at the economically sensitive stuff in the market, it’s not really selling off. It’s tech. It’s bio-tech [which makes up about 10 percent of the market.]  The other 85 to 90 percent is in perfectly fine shape.

This weekend Barron’s patted itself on the back for predicting the tech bust several months ago:

In November, when pundits began to natter about a stock market bubble, we pointed out in a prescient cover story that it was a tech bubble, not a market bubble.  Our advice has paid off handsomely.

Barron’s quoted perma-bull Jim Paulsen, chief investment strategist at Wells Capital Management:

My guess here is that we’re having a valuation adjustment in one small part of the market, in the highflying momentum stocks that got ahead of themselves and are now correcting.  I think this is more of a buying opportunity.

The article concluded:

All this suggests that despite some ominous headlines, the stock market’s health is still good. [emphasis added]

Where are the ominous headlines?  We don’t see any.  We see complacency as far as the eye can see with the assuredness that the momentum stock bust is “contained.”  We heard these same words in April, 2000 after the dot-com bust and March, 2007 after the subprime bust… early warning signs that were overwhelmingly ignored.

Greenspan sees no bubble

The Maestro’s crystal ball is the gift that keeps giving.  With an uncanny knack for completely missing most of the major inflections points in financial markets over the past five decades, Greenspan added this gem to his resume in a FOX Business News interview yesterday:

“There are a lot of things that can go wrong, but to say that the market is bubbly and in a position where it could conceivably create a serious problem, I think is overstating it.”

Let’s put this prediction in perspective by filling in some of his resume…

“It’s very rare that you can be as unqualifiedly bullish as you can now.”  ~ Alan Greenspan, The New York Times “Economic Survey”, January 7, 1973

1973 and 1974 turned out to be the worst years for economic growth and the stock market since the Great Depression.  (as noted in Jason Zweig’s commentary in The Intelligent Investor)

On October 2, 1990, then Federal Reserve chairman Greenspan made this prediction:

“At the moment it isn’t raining.  The economy has not yet slipped into a recession.”

It was later revealed that a recession had actually begun three months earlier, in July.

In April 2000 (one month after the NASDAQ peak), Greenspan was asked if rising rates would prick the stock market bubble.  His response:

“That presupposes I know that there is a bubble…  I don’t think we can know there’s a bubble until after the fact.”

From The Age of Turbulence (2007), Greenspan recounted his thoughts on the 2003-2006 housing bubble:

“I would tell audiences that we were facing not a bubble but a froth – lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.”

The December 26, 2005 issue of BusinessWeek confirmed his complacency:

“The view of most economists, including Fed Chairman Alan Greenspan, is that a national home-price bust is highly unlikely.”

Greenspan also whistled past the subprime lending grave:

“With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. . . . This fact underscores the importance of our roles as policymakers, researchers, bankers and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers.”  ~ Alan Greenspan, from a speech given April 8, 2005

Housing prices peaked in Q1 2006 and by Q4 were in full retreat, yet Greenspan was unconcerned:

“Most of the negatives in housing are probably behind us.  The fourth quarter should be reasonably good, certainly better than the third quarter.”  ~ Alan Greenspan, October 26, 2006

Even as late as Q2 2008 he thought the worst was over:

U.S. financial markets, roiled by the collapse of the subprime-mortgage market, have shown a pronounced turnaround since March. The worst is over for the credit crisis, or will be soon, and there’s now a reduced possibility of a deep recession.  ~ Alan Greenspan, June 13, 2008

The S&P 500 plunged nearly 45% over the ensuing five months.

Alan Greenspan is a stark reminder that central bankers have only one productive use: as contrary indicators.

A bubble in talk of “no bubble”

It doesn’t matter how untrue a thing is. If enough people (especially people we look up to) repeat it often enough, it soon becomes conventional wisdom.  A hundred years ago, Gustave Le Bon understood this when he wrote his classic work on crowds. He realized that the popular mind wanted most of all to simplify things.  Le Bon called the process – by which an idea gets simplified, repeated, imitated, and spread by the crowd – contagion.  ~ Bill Bonner and Lila Rajiva, Mobs, Messiahs, and Markets (2007)

The contagion du jour is talk of “no bubble.”  For example, here are a few headlines just from this morning:

“If bubbles are out there these 10 sages will warn us” – MarketWatch

“Resistance is futile for staunch market bears” – MarketWatch

“Nasdaq tops 4000: why it’s nowhere near a bubble” – Yahoo!Finance

Here is what the experts have to say on the subject:

“Stocks are not selling at bubble levels, and, what do you diversify into? Do you want to diversify into cash? I think it’s a terrible investment compared to equities.  ~ Warren Buffett

“Stock prices have risen pretty robustly.  You would not see stock prices in territory that suggest…bubble-like conditions.”  ~ Janet Yellen

Of course, these are the same pied pipers who walked investors into the fire during the 2006-2007 credit bubble:

“Overall, the consumer is never going to sink the economy.”  ~ Warren Buffett, CNBC, May 7, 2007

“I’m waking up less at night than I was [over the slowdown in housing]. So far, there’s been remarkably little effect on the rest of the economy.”  ~ Janet Yellen, San Francisco Fed President, MarketWatch, February 21, 2007

In fact, at least one economist is so unconcerned about bubbles that he thinks they come with a silver lining:

“We may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest.”  ~ Paul Krugman

This is the same economist who was egging on the Fed to foment a housing bubble in 2002:

“Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”  ~ Paul Krugman, “Dubya’s Double Dip?,” The New York Times, August 2, 2002

Personally, we subscribe to the views of Marc Faber:

“I see a bubble in everything that relates to the financial sector.  We have a bubble in bonds. We have a bubble in low-quality bonds. We have a bubble in equities…We have a huge debt bubble and it’s only getting bigger, it’s not getting any smaller. So we are the bubble, everything that is in the financial sector is the bubble, and it’s been pumped up by central banks.”

Bears feeling the pressure

During manias, the pressure to conform becomes… well, unbearable.  Yesterday, CNBC reported that noted bear Doug Kass put an end to the scorn he constantly received on Twitter:

Doug Kass has had it with the haters and declared his intent Monday to leave Twitter and his 62,000 followers behind.

He has been consistently bearish during the current market rally and has taken substantial heat for his position that stocks are overvalued and headed for a fall.

But he said he’s tired of the constant procession of personal attacks and is packing it in.

This reminds us of the pressure to conform during the housing and credit bubbles from 2004-2007.  Prominent bear Fred Hickey wrote the following in the October 4, 2007 issue of his monthly newsletter, The High-Tech Strategist:

Fellow contrarians, it’s gut-check time.  As a standard bearer of the camp that believes that the Federal Reserve is not omnipotent, I can tell you that this moment is as difficult as any that we have had to endure in many years.  I speak to many of the most hard-core stock market bears (our circle is a small one) and it is clear that their confidence is on the ropes.  I’m not sure if I can characterize it as despondency, but it sure is close.  I can hear the depression over the phone.  Their tone is subdued and there’s an air of despondency.

I’d be lying if I said I wasn’t feeling the pressure.

Someone left me a message this week whining that with the housing market in a total collapse, the Fed will never allow the stock market to fall because the consequences would be so awful.  It was his conclusion, therefore, that stocks were destined to go higher.  Resistance was futile.

It is the notion that the Federal Reserve is in complete control of the markets that is propelling this latest bout of insanity.

History doesn’t always repeat, though it often rhymes.  The near extinction of the bears is perhaps the best sign that the investment winds are about to change as the Fed-induced economic storm clouds build.

Bond funds reaching for risk

It seems everyone is tempted to indulge just a bit more than they should during this wild financial party hosted by the Bernanke Fed.  Those in money market funds are buying short-term bond funds.  Municipal bond owners are extending maturities.  Bond investors are venturing into exotic places like Rwanda and Bolivia.  And now, according to a May 1st Wall Street Journal article, “Bond Funds Running Low On… Bonds,” a total of 352 mutual funds classified as “bond funds” by Morningstar now own stocks. That’s up from 283 in the first quarter of 2012.

“The number of bond funds that own stocks has surged to its highest point in at least 18 years.”

A similar phenomenon occurred during the late ’90s tech bubble as investors simply couldn’t resist the temptation to push the envelope for greater returns.  Remarked Ehrenkrantz King Nussbaum strategist Barry Hyman on December 22, 1999:

“Value players have become growth players, growth players have become momentum players, and momentum players are out of their minds.”

History doesn’t always repeat, though it often rhymes.

Wall Street sausage factory spits out “income” funds

According to a brief article on MarketWatch,

Apparently marketing does make a difference, at least in the mutual-fund world. With interest rates having cratered as a result of the Federal Reserve’s post-recession stimulus policies, retirees and other investors have been scrambling to find investments that will produce the income they aren’t getting from Treasurys and other low-risk bonds. Concisely illustrating that very point, Russ Kinnel, the director of mutual fund research at Morningstar, tweeted this today:

For past 12 mo, the amount of $ flowing into funds with “Income” in their name is 3X larger than funds without “Income” in their names.

If Main Street demands “income,” Wall Street’s role is to comply and supply.

Beware ultrashort-bond funds

The reach-for-yield bubble continues to scale record heights of insanity.  The latest milestone: the recent popularity of ultrashort-bond funds.  These typically invest in high-quality bonds with maturities, on average, of less than a year.  According to a June 3 Barron’s article, “When It Comes to Cash, Less Is More“:

For the trailing one year through April 30, the nearly 50 ultrashort funds tracked by Morningstar have taken in $10 billion in new assets.  “That’s pretty big considering that there’s $52 billion in the entire category,” notes Morningstar analyst Timothy Strauts.

While this is a drop in the bucket compared to the $895 billion in retail money market funds, the vigor in which fund companies are marketing this product should raise red flags:

In the past year alone, roughly a half dozen new ultrashort-bond funds have made their debut – the BlackRock Short Obligations fund, Sterling Capital Ultra Short, and T. Rowe Price Ultra Short-Term Bond among them.  In May, Legg Mason’s subsidiary filed SEC documents for the Western Asset Ultra Short Obligations Fund.

According to Morningstar, ultrashort-bond funds have an average 30-day yield of 0.59%, but is this worth the extra risk?  During the financial crisis, many of these funds posted losses.  In fact the largest at the time, Schwab YieldPlus, lost 35% of its value in 2008.

“Our feeling on ultrashort bonds right now is ‘What’s the point,” says Jeremy Welther, a principal at Brinton Eaton, a financial advisory based in Madison, NJ.  “Any time you get back less than what you put in, it’s not cash.”

Besides gold, cash appears to be the most unloved asset class on the planet.

Cracks in the sovereign debt bubble?

2013 started with a roar as risk assets rallied off of late 2012 QE-to-infinity rhetoric from both the Federal Reserve and the Bank of Japan.  As speculative juices continued to flow we witnessed a new all time high in NYSE margin debt (April) coupled with a new high in covenant lite levered loans (double the peak in 2007).

Predictably, along the path to QE addiction is a road paved with economic casualties.  One example of the real economy hitting road blocks is the Caribbean sovereign debt debacle.  According Bloomberg:

Jamaica and Belize, which restructured about $9.5 billion in local and global bonds this year for the second time since 2006, face a “high probability” that they will default again, Moody’s said in a May 20 report.

Among Caribbean island economies, only the Bahamas is expected to grow more than 1.5 percent this year compared with 4 percent for Latin America, Moody’s said in an earlier report. Without faster growth, repeat defaults may become common as Caribbean governments find it easier to cut bond payments than spending, said Arturo Porzecanski, a professor of international finance at American University in Washington.

Maybe the professional speculator accessing cheap financing from his prime broker to buy “distressed sovereign debt” should consider the following:

“These countries are exhibiting an increased unwillingness to pay,” according to Arturo Porzecanski, a professor of international finance at American University in Washington. “We may be seeing the birth of a region of serial defaulters.”

Takeaway: Like Cyprus and Greece the tipping point for many of these small, tourist dependent nations appears to be roughly 110% of debt-to-GDP.  This begs the question, “How much longer can countries such as Spain, France, Japan and Portugal put off the day of reckoning?”