Two Signs That Imply Emerging Markets Are Getting Overheated

Michael Krause submits: The size of a fund has little to do with the market value of the index it tracks. For example, the Utilities Sector SPDR (XLU) is almost as large as the Technology Sector SPDR (XLK), at $3.9 billion and $4.3 billion in assets, respectively. However, in the S&P 500 the market cap of the Tech sector is more than six times that of the Utilities sector. Rather, it reflects investors’ propensity to play the Utilities sector using ETFs, whereas single stocks and perhaps actively managed mutual funds are the preferred vehicle for Tech sector investing, at least relatively speaking. The same holds true with Emerging Market ETFs, which now have assets exceeding $112 billion by our count versus $71 billion for ETFs tracking developed foreign markets, despite the much larger size of developed markets (Figure 1). While fund size doesn’t say much about the investment merit of the index it tracks, fund flows and short interest may serve as contrary indicators. Rapid changes in fund assets may indicate “hot money” chasing returns, while short interest—that is the percentage of shares outstanding that have been borrowed for short sales—tells us about levels of skepticism (or lack thereof).Over the past three months while U.S. and European markets stumbled, the S&P 500 SPDR (SPY) and iShares EAFE funds (EFA) also saw declines in the number of shares outstanding of 5.5% and 2.7% respectively, while the iShares Emerging Markets fund (EEM) had a rapid increase of 14% (Figure 2).Also of concern is that short-interest appears to show an unhealthy lack of skepticism about emerging market stocks, with only 5.5% of EEM shares held as short sales, compared to 8.2% for EFA and 48.9% for the SPY. Lastly, we also note that the difference in ALTAR Scores™ -- our rating of an ETF's overall investment merit -- between EEM and SPY of 1.5% (in favor of EEM) is smaller than usual. This is not to say that emerging economies aren't in better shape (in general) than developed ones. Rather it simply appears that emerging market stocks have become relatively richly valued, at least historically speaking, and it seems that buliishness is rampant, a warning sign in our opinion. Figure 1: Equity ETF Assets by Category ($billions)Complete Story »