3 Reasons for Caution on Stock ETFs

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( ETF Expert) -- If you've been a longtime reader, you know that I regularly call out "permabull" or "permabear" thinking. I don't believe that it is sensible to listen to a financial adviser who always sees the glass as half full or follow someone who always sees the glass as half empty.

At the same time, I actively manage money for my clients -- I am not a static asset allocator. And that means I must make information-based decisions about the percentage of riskier assets to hold. Specifically, I make changes to the asset allocation when there is an abnormally high level of downside risk or when upside opportunities arise.

For example, I might reduce a moderate growth portfolio down from a 65% growth/35% income allocation to 40% growth/45% income/15% cash. In contrast, there may be times when I bump up the moderate growth target allocation from "65%/35%" to "72%/28%."

As an active manager of exchange-traded investments, I use a wide variety of ETF indicators to make my decisions. And while those choices may make me seem more "bullish" or "bearish," I'm less apt to describe myself as a member of either camp.

More accurately, my chief responsibility is to minimize the risk of loss. Exchange-traded stock index funds take care of their upside performance quite well, but they won't get you out of a jam by themselves. Active stewards of risk, however, control investment outcomes. They make certain each outcome is either a big gain, a small gain or a small loss ... no big losses!

It follows that, in light of the staggering five-day market upswing of 5.4% in the S&P 500 recently, perspective is warranted. Specifically, here are three reasons why stock ETF investors might want to refrain from jumping back into the shark tank with both feet.

1. Significant Underperformance for Emerging Markets. It's one thing to view emerging-market volatility as "too much" for a low-risk portfolio. It's another thing to see emerging markets fall further on the downside, yet barely rise on the upside.

Granted, some of this is due to the recent safe haven seeking of dollars over Asian and other emerging-market currencies. What's more, emerging markets may have more at stake in a potential European recession.

Nevertheless, the price-to-earnings ratios for many key ETFs, from the SPDR BRIC ETF ( BIK) to the iShares South Korea Fund ( EWY), are surprisingly low in relation to U.S. exchange-traded index funds. And the performance gap is wider than at any point over the last year. (See the chart below.)

In many instances, these are healthier economies with superior growth prospects, low debt, trade surpluses, low unemployment and a leash on inflation. It follows that, until emerging markets rally convincingly, it's difficult to have confidence in the sharp U.S. equity move higher.

2. Canada and Australia. Even if one is quick to dismiss the emerging-market underperformance, how can one be quick to dismiss the strongest economies (at present) in the developed world? Australia and Canada are both projected to grow at a faster clip in 2012 than the U.S.; Canada and Australia both have a better employment situation.

Nevertheless, the S&P SPDR Trust ( SPY) picked up 5.4% in five days, while iShares MSCI Australia ( EWA) logged a feeble 0.4% and iShares MSCI Canada ( EWC) registered a paltry 0.8%. This one can't even be blamed on faltering currencies, as the CurrencyShares Canadian Dollar ( FXC) gained roughly 1.5% on the dollar over the week.

One might say that energy-rich Canada and materials-rich Australia are slumping due to a slowdown in the global growth story. Fair enough. Yet if that slowdown is real, it would hit U.S. equities sooner or later. Once more, without these healthier developed countries rallying, one would need to curb one's enthusiasm for the five-day U.S. phenomenon.

3. Commodities Still Faltering. This week was "risk on" for the U.S. alone. And while that may have a great deal to do with the dollar's gains, relief over Europe and/or perceived safety of U.S. multinationals, there's no ignoring global growth fears.

PowerShares DB Base Metals ( DBB) was down 1.0% over the week. iPath DJ Copper ( JJC) lost 1.7%. PowerShares DB Agriculture ( DBA) lost 3.1%.

Commodity stocks, which do not necessarily correlate with the underlying commodities and frequently correlate with the equity markets themselves, also struggled. Market Vectors Coal ( KOL) gave up 0.6%, Market Vectors Rare Earth Miners ( REMX) fell 1.1% and copper-heavy iShares MSCI Chile ( ECH) lost 4.3%.

We can blame the dollar for some of the angst. Yet the evidence suggests that, even with sovereign debt band-aids, a return to bull market form will require foreign market participation. That is, without global economic growth showing definitive signs of improvement, U.S. stocks can only climb so far.

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Disclosure Statement: ETF Expert is a website that makes the world of ETFs easier to understand. Gary Gordon, Pacific Park Financial and/or its clients may hold positions in ETFs, mutual funds and investment assets mentioned. The commentary does not constitute individualized investment advice. The opinions offered are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationships. You may review additional ETF Expert at the site.

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