ETFs and Systemic Risk, Too Much Inventory, and Introducing Empire Real Wealth

(This originally ran on Empire Financial Research. )

Was I wrong, or was I just early?

Back in 2010, while I was working for CNBC, we did a series called "Man vs. Machine " about the role computers and high-frequency trading were playing.

The series followed a machine-generated "flash crash" that sent shockwaves through the markets...

In retrospect, the entire series was well ahead of its time.

My focus was on exchange-traded funds ("ETFs"), with my report starting out...

Since the May 6 Flash Crash there has been growing concern that exchange-traded funds are a monster in the making – certainly something bigger than they were meant to be.

The concern at the time was that ETFs could become the 'tail wagging the dog'...

An estimated 68% of bad trades during the flash crash involved ETFs. As I wrote...

While it's impossible to fully quantify any true impact of ETFs, worries extend to their role in the changing nature of how people invest and to the market's high correlation to itself.

At the time, there were around 1,100 ETFs with $1 trillion in assets – double the amount over the previous four years.

The popularity of ETFs has continued to explode. According to global research firm ETFGI, earlier this year, there were nearly 9,000 ETFs worldwide with roughly $10 trillion in assets...

Among those are theoretically the most dangerous of all: leveraged ETFs, which can cause multiples of damage.

And now, given arguably the wildest volatility the market has ever seen, some questions haven't yet been answered...

What role have ETFs played?

Have they exaggerated whatever the underlying market volatility would have been?

Most important, do they cause systemic risk?

If there was ever a test, you would think, given this market...?that would be now.

And if this period isn't being put under a microscope, shame on everybody.

Two years ago, the CFA Institute put together a panel on the topic of ETFs and systemic risk. A?story ?reporting on the event quoted an adjunct professor at Fordham University's business school, Jayesh Bhansali, as saying...

While most ETFs track liquid equity indexes, one of their key features is related to the capacity to also replicate baskets of less liquid assets and form more liquid tradable surrogates. But as we all know, this so-called magical liquidity transformation has a tremendous friction cost attached.

He went on to quote from a?Moody's report , which nailed it (emphasis added)...

The ETF market has grown rapidly during a period of relative calm, meaning that it has yet to be tested by a period of high market distress or volatility. Unexpected market liquidity shortfalls could be most pronounced with an ETF tracking inherently less liquid markets such as high-yield credit.

He added that the report also said...

These ETF-specific risks, when coupled with an exogenous system-wide shock, could, in turn, amplify systemic risk.

A study from the CFA Institute Research Foundation raised its own concerns, concluding that while evidence may not yet be clear, "For now, the evidence is consistent with ETF behavior exacerbating market volatility in stressful times."

The passive nature of indexes – and the way they can swing by virtue of headline-driven algorithms – adds to the concern. It's unclear what percentage of the stock market is passive. I've seen estimates ranging from 15% to more than 50%, suggesting nobody has a clue.

What's clear is that the structure of the market is different than it was in the market-rattling flash crash of 2010, which is obvious during market calamities.

As the CFA Institute report puts it...

In recent years, the frequency, suddenness, and ferocity of such market disruptions have surprised both regulators and market participants.

And that was written while the market was still marching higher.

Let that sink in...

Moving on, if you've been out shopping lately, you may have noticed that stores have gone from no inventory to too much inventory...

I've heard from merchant after merchant saying the same thing: They can't keep up with the amount of inbound goods.

Now that the supply chain is unclogged, it's truck after truck, shipment after shipment... There simply isn't enough space to put everything or time to sort through it all.

The reason can be seen in the chart below, which shows a collapse in the number of ships waiting to get into port at Los Angeles...

My friend and neighbor Jeff Macke follows all things retail. He added a new twist in a response to some of my tweets on the topic...

And based on cargo data no one has anything coming between now and the end of the year. I think the stores all shipped Christmas last month (and even August) in response to last year's mess. The timing is off everywhere but I doubt inventory is as bloated as feared.

That doesn't mean there won't?still?be some more great clearance sales. As a clerk at REI told me over the weekend, "We had things go straight from the truck to 70% off."

I'm guessing there will be more where that came from.

Finally, I'm thrilled to announce we've just launched my newest product,?Empire Real Wealth...

Our initial portfolio is nine companies. They're all big and solid, with great histories and – if we're right – excellent future prospects... Plus, as a group, they trade at a 25% discount to the S&P 500?and?yield 3.5%, twice that of the large-cap index.

In other words, it's?perfect?for this market.

Only Empire Financial Partners and Empire Junior Partners have access to the issue, which will be available to the general public in the coming days.