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Emerging Markets: The Next Fed-Inspired Bubble?

Let's see what asset class ends up with that excess liquidity.

The Fed hit the market with a surprise 50-basis-point discount rate cut that caught many traders leaning the wrong way Friday. The rate cut came in response to the subprime crisis and is giving the credit markets the one thing that they need the most, liquidity.

The Fed is hoping that by injecting liquidity into the credit markets, it can avert a meltdown of the financial system. If the Fed has to take further action in response to the subprime crisis and continue pouring in liquidity, we may see another asset bubble created. This time, the bubble may be created in the emerging markets.

The case for this happening is simple and hangs together well. Each time the Fed has responded to a financial crisis by lowering rates, the surge in liquidity has led to the creation of an asset bubble. Each asset bubble then collapsed and led to the next crisis.

Follow me. The 1997-98 Asian crisis led to rate cuts as the Fed poured in liquidity and stabilized the economy during the global financial crisis. This action worked, but the excess liquidity led to the technology bubble and implosion in 2001.

The bear market created by the "tech wreck" prompted the Fed to cut rates and once again inject liquidity to counteract the effect of collapsing stock prices on the economy.

The excess liquidity created this time led to the housing bubble and the subprime disaster, as lenders abandoned good lending practices during the speculative frenzy.

Now the Fed is reacting once again by cutting rates and injecting liquidity. A rational person has to see the pattern here. We believe that the excess liquidity created this time will flow someplace and create another bubble. The emerging markets are an excellent candidate.

Bubbles need a theme or a concept behind them, and it needs to be new. Investors are unlikely to create a bubble in the same asset class within living memory. What we mean by this is that traders are unlikely to go back and create a new tech bubble while the memory of the last collapse is still fresh.

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A much more likely scenario is that investors find something new to get excited about and create a bubble in a fresh investment theme. The emerging-markets story has everything needed to create an asset bubble.

The opportunity there is potentially enormous, while being hard to define. It's simply a great story, and the strength of these markets over the last couple of years should attract liquidity, creating a "virtuous" cycle to the upside.

The Fed action will have consequences, and we would keep a close eye on where the liquidity flows as the Fed tries to clean up the subprime lending disaster. A relatively small amount of liquidity could push these emerging markets into overdrive in the coming year.

iShares MSCI Emerging Market ETF

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A great way to capture a bullish change in the emerging markets is with the

Emerging Markets Index ETF

(EEM) - Get iShares MSCI Emerging Markets ETF Report

. This ETF mimics the MSCI Emerging Markets Index, which measures global emerging equity markets performance. EEM has pulled back sharply during this correction, but the fund has held the long-term uptrend channel. Buy the fund at this level and use last Thursday's lows as a stop-loss.

At the time of publication, John Hughes and Scott Maragioglio had no positions in the stocks mentioned. Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.