Financial "Trompe L'oeil"

During the Renaissance, Flemish painters perfected the art
of "trompe l’oeil" – creating such incredibly lifelike
paintings that the images on the canvass literally "tricked
the eye." In 2005, exchange traded funds (ETFs) sometime
create equally "lifelike" deceptions.

We strongly suspect, although we cannot prove it, that ETFs
sometimes exaggerate the price trends of their underlying
securities. In the process, ETFs may be fostering temporary
illusions of strength or weakness in a given stock market

Illusions on a canvass inspire awe; illusions on a computer
quote screen inflict costly bewilderment.

ETFs arrived on the scene as exchange-traded mutual funds
that would reflect the trends of a given sector. But some
of the most popular ETFs have become so influential that
they sometimes CREATE demand for the very stocks that they
purport to mirror.

Here’s why: Market makers create and/or dissolve specific
ETFs in response to the fluctuating demand for them. The
market markets will create or dissolve as many ETF shares
as needed to keep the price of the ETF close to its net
asset value (NAV). Whenever demand for a given ETF surges,
therefore, market makers will create additional ETFs
shares, while simultaneously purchasing the underlying
stocks that comprise each ETF.

For example, to create shares of EEM, the ETF for the MSCI
Emerging Markets Index, the market makers must literally
purchase stocks all over the globe, from markets as far-
flung as Brazil, Turkey, Russia and South Korea. Obviously,
therefore, if investors suddenly swarm in to buy shares of
EEM, the market makers must swarm in to buy shares of
things like Kepco, the South Korean electric company.

Since Kepco is a pretty large and "liquid" stock, a surge
of buying from EEM market makers might not cause much of
jump in price. But many of the less liquid issues that
comprise the EEM ETF might jump dramatically when the
market makers show up with their bids. Buying by ETF market
makers, therefore, can create a "virtuous cycle" in which
their buying boosts the price of underlying stocks, which
attracts additional ETF buying, which boosts the price of
underlying stocks even more.

Clearly, the robotic buying by market makers occurs in
response to their need to hedge exposures. It does not
occur because thinking investors – one by one – make the
decision to buy a given stock. Sometimes, therefore, this
robotic buying can create an appearance of strength that is
somewhat illusory.

The number of EEM shares outstanding has been expanding at
a very rapid clip over the last few months. But we find it
curious that the EEM rally between January and March
produced a very modest – and lagging – demand for
additional EEM shares. By contrast, during the most recent
advance, the demand for EEM shares seemed to LEAD the
rally. In other words, the tail seemed to wag the dog.
Clearly, the itty-bitty $4 billion EEM could not create an
emerging market rally all by itself. But it could
nevertheless contribute to the move.

ETFs are a wonderful creation – one of the greatest
financial innovations since the IOU. But as their
popularity grows, so does their influence. "Underscoring
the explosive growth of ETFs," reports, "in
2004 Barclays Global ETFs posted $43.8 billion in net
inflows, more money than went to Vanguard and Fidelity."
Worldwide ETF assets jumped nearly 50% last year to more
than $300 billion.

Already, ETF trading accounts for three quarters of all
transactions on the American Stock Exchange. And the volume
figures are also growing rapidly worldwide. Morgan Stanley
reports that ETF trading volumes worldwide jumped almost
30% last year.

So even though $300 billion is not a terribly large amount
of money in relation to the global stock market
capitalization, ETF trading volumes have become a sizeable
market influence.

Trompe l’oeil, as an art form, relies upon a scientific
symmetry to create its effect. "The discovery of linear
perspective in fifteenth century Italy,"
explains, "and advancements in the science of optics in the
seventeenth-century Netherlands enabled artists to render
objects and spaces with eye-fooling exactitude.

The stock market’s trompe l’oeil also relies upon a kind of
symmetry – a symmetry that finds expression in the phrase:
"What goes up may also go down." If an ETF can exaggerate
the upside behavior of a specific market sector or foreign
market, we would be alert to the possibility that it could
also exaggerate the downside.

Did You Notice…?
By Eric J. Fry

To some investors, the chart below might seem to portray
nothing more than an unintelligible squiggle. Perhaps
that’s all it is. But we think we see a sign in this
squiggle that the current oil rally will take a
breather…very soon.

We think we see the painful short-squeeze of traders who
had been buying long-dated crude futures and simultaneously
selling short near-term crude futures. In fact, the
"adjustment" pictured on the right hand side of the chart
has occurred so swiftly that we think we can almost hear
the agonized screams of speculators who are finding
themselves on the wrong side of a very big move.

For most of the last two years, the December 2007 futures
contract for crude oil sold for several dollars less than
the July 2005 contract. That’s a fairly ordinary
configuration known as "backwardation." However, as the
rally in crude oil gathered steam late last year – raising
the prospect that $50 crude oil might not be a "temporary"
condition – oil traders began to "bid up" the prices of
long-dated crude futures.

As the chart above illustrates, the spread between December
2007 crude and July 2005 narrowed from "$9.00 under" in
mid-March to nearly $2.00 OVER last week.

At first, the narrowing of spreads between long-dated crude
futures and near-month contracts caught many "seasoned" oil
traders off guard. But eventually, they embraced the
spread-narrowing trend as a relatively "low-risk"

For a while, traders minted money by buying long-dated oil
and selling short near-month contracts. But this trend of
this spread reversed with a vengeance early last week.
Specifically, the price of July 2005 crude oil jumped $4 in
a few days while the price of December 2007 oil actually

In other words, the final $3 to $5 of last week’s crude oil
rally may have had more to do with the unwinding of ill-
fated hedge trades than with any real-world demand for
crude oil.

Our theory might seem a little complex to novice investors,
but suffice to say that we distrust the last few dollars of
the recent oil rally. We still love the black gooey stuff
as a long-term investment. But we are wary for the moment.

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