Financial Time Bombs Hiding in Plain Sight

The bear will soon be arriving in earnest, marauding through the canyons of Wall Street. Our monetary central planners will once again — for the third time this century — be utterly shocked and unprepared.

That’s because they have spent the better part of two decades deforming, distorting and destroying what were once serviceably free financial markets. Yet they remain as clueless as ever about the financial time bombs this inexorably fosters.

Central bank stimulated financial asset bubbles crash. Every time.

Accordingly, the casinos are populated with financial time bombs like never before. Worse still, the central bankers are now so utterly lost and confused that they are all thronging toward the one thing that will ignite these time bombs in a fiery collapse.

We will treat one of the time bombs set to explode in the section below. But first it needs to be emphasized that the third bubble collapse of this century is imminent. That’s because both the global and domestic economy is cooling rapidly, meaning that recession is just around the corner.

So there will be carnage in the casino when it becomes evident that recession has again visited this fair land. But that the Fed is utterly out of dry powder.

There are financial time bombs are lurking everywhere in the global economy — even if the central bankers don’t see them coming.

So we are looking at tens of trillions of financial asset shrinkage in the years ahead. And nowhere will that implosion be more dramatic than in the ETF sector.

The number of these entities has grown from about 600 to 5,500 in the last 12 years, and assets under management (AUM) has exploded from $450 billion to $3 trillion.

That’s a 21% compound rate of growth since 2005. Even more significantly, almost all of that growth occurred after the 2008 financial crisis.

Prior to Greenspan’s dotcom bubble, ETFs did not even exist, and they would never thrive on an honest free market. That’s because their fundamental appeal is to professional speculators and traders and to homegamers who like to bet the financial ponies.

By contrast, there is no reason why real long-term investors would want to own a huge, assorted basket of banking stocks or energy stocks. Or the likes of what’s in the biotech ETF portfolio. The latter (IBB) includes 150 different stocks, including nearly 100 start-ups whose science is extremely difficult to assess. Their profit and loss statements (P&Ls) are also largely non-existent.

The sole purpose of the IBB was to enable speculators to pile on to the momentum trade in biotech stocks, which began about 2012. This momentum trend was then turbo-charged by the inflow of speculative capital into this sector through IBB and other ETF’s.

The same thing happened with the energy ETFs. One of the major ETF baskets in this sector is called XLE and it includes 40 energy companies. These range from giant integrated producers like Exxon to refiners like Valero, to oilfield services companies like Halliburton, to small E&P companies like Newfield Exploration.

The iShares equivalent is called IXC and it is even more diversified, with 96 companies spread among an even greater diversity of sizes, specializations and geographies.

No long-term investor would possibly believe that such a hodgepodge of industries can be rationally analyzed at the company specific level. After all, the whole point of competitive markets is to sort out the winners, losers at the sector, industry and sub-industry level. So buying the entire industry in a single stock amounts to embracing self-cancelling financial noise. That undoes all the hard work Mr. Market performs at the operating performance level.

Exchange traded funds, at bottom, are products of the financial casinos, not the free market. They offer traders and speculators the chance to “bet on black” for just hours, days or weeks at a time, based on little more than headlines and momentum. Not surprisingly, the XLE has now completed a round trip to nowhere during the last five years as the oil bubble re-erupted and then collapsed.

The massive amount of trading that occurred continuously up and down along this trip to nowhere was economically pointless. It was a playpen for speculators and robo-machines. It didn’t allocate capital efficiently or add market liquidity to the real enterprise of American capitalism.

The implication is straightforward. The ETF boom functioned as a market accelerator on the way up. Speculative capital poured into these proliferating funds, and then was transformed by Wall Street market makers into demand for the thousands of individual stocks that comprise them.

This magnifying effect is important to understand because it highlights the artificiality and instability of today’s stock markets. Every time an ETF started trading above the net asset value of the underlying stocks due to speculator buying, fund providers issued new ETF shares to market makers.

These market makers, in turn, bought up a basket of shares on the stock exchanges representing the asset mix of the fund. They then swapped them for the ETF shares.

We call this the Big Fat Bid that helped undermine the two-way market forces that ordinarily keep speculation in check. But now that the worldwide financial bubble is cracking, we believe the dynamic will begin playing out in reverse. That is, ETFs will now become the Big Fat Offer that takes the market down at an accelerating pace.

The reason is straightforward. The $3 trillion world of ETFs is not an investor marketplace. It is a casino where the fast money moves in and out of short term rips, bubbles and flavors of the moment; and also a dangerous place where naïve retail investors have been lured to roll the dice on their home trading stations.

So as the global economy and financial markets slide into the long, deflationary cycle ahead, the hot money will flee sinking ETFs at an accelerating pace. Homegamers will be shocked to find that they have been fleeced by Wall Street yet again. At length, retail level panic will ensue, causing a thundering implosion of the ETF sector.

What lies ahead for retail investors is probably worse. That’s because ETFs inherently embody a liquidity mismatch. Almost invariably the underlying stocks are not as liquid as the ETF shares which represent them.

This means that retail investors may be faced with painful episodes in which ETF shares gap down violently to deep discounts relative to their net asset value. Accordingly, if shareholders have attempted to protect their portfolios with stop orders, they may be handed sharp losses. Or they may just panic and sell.

The market plunge on August 24th last year provided a foretaste. In today’s markets, “trading halts” occur when a stock moves up or down too quickly relative to the trading range contained in market circuit breakers. Ordinarily, about 40 such trading halts occur each day, but during the August 24th plunge there were almost 1,300 such occurrences. And 78% involved ETFs, not individual stocks.

This is crucial because ordinarily only one-third of trading halts involved ETF shares. Stated in round numbers, there are ordinarily about 15 ETF trading halts per day, but on August 24th that number soared to 1,000.

Moreover, during this trial panic, the risk of large pricing gaps was painfully evident. The Vanguard consumer staples ETF called VDC, for example, plunged by 32% that day while the underlying holdings of the fund dropped by only 9%. Retail investors who panicked or who were sold out by stop loss orders were taken to the cleaners by the market makers.

The point here is not a plea for SEC regulation. Far from it!

Instead, the implication is that after a few more such episodes during this unfolding bear market — which must inexorably happen due to the liquidity mismatch — retail investors will become thoroughly disgusted with ETFs. They will then head for the hills right behind the fast money on Wall Street.

Yet ETFs are only one of the many FEDs (financially explosive devices) that have been fostered by our rogue central bankers. Wait until $700 trillion of financial derivatives start living up to the name Warren Buffett gave them before he went all in using them (“financial WMDs”).


David Stockman
for The Daily Reckoning

P.S. No one sees this crash coming. It’s not an exotic hedge fund. It’s not derivatives on real estate or commodities. It’s not even speculative options… it’s worse. It’s likely buried deep in your retirement strategy. And you may not even be aware. It’s a fatal flaw in the most popular financial innovation of the 21st century — a specific type of investment that’s about collapse…

Setting ablaze more than $1 trillion of ordinary investors’ money. You’ll want to make sure you’re not one of the victims. That’s why I’m hosting a FREE live event next tonight at 7 p.m. EST to give you all the details.

Click here now to reserve your spot. But hurry. These events fill up fast. So sign up today.

The Daily Reckoning