ETF Expert

Readers as well as radio show listeners know that I often poke fun at Morningstar guidance. That goes back to the days when they had 5-star ratings for each fund in the Janus family circa 1999; it also relates to the company's late acceptance of exchange-traded funds.

Nevertheless, Morningstar has powerful databases. While their analysts discuss "fair value" in terms of a proprietary fundamental approach that ignores historical, psychological and technical information, patterns often emerge from Morningstar screens.

Here are the 3 criteria that I used to identify ETFs that may be hitting "overbought" status:

(1) 3-Month Return. In May and June, many stocks found themselves stuck in a trading range. In fact, the bull run from March 9 to May 8 had effectively been stymied over the next two months (May 9-July 8). Then came an earnings season that investors wholeheartedly embraced, and July roared ahead. By looking at 3-month returns for ETFs that exceeded 25%, we're looking at ETFs that not only weathered the May/June slumber, but more than doubled (in some cases tripled) the 3-month return of other stock assets.

(2) 3-Year Standard Deviation. Standard deviation is a measure of risk. The greater the percentage, the greater the risk. For instance, an exchange-traded fund that averages 7% per year with a standard deviation of 15% should typically return between -8% and 22%. So if that's not volatile enough, we're taking a look at ETFs that have standard deviations north of 30%; in effect, the greater the volatility, the more prone the ETF may be to a severe pullback.

(3) Price-to-Fair Value. Easily the most subjective of "numbers," we're looking at ETFs where the current price is above what Morningstar rates as a Fair Value price. A ratio of 1.01 or above suggests that, at least in Morningstar's eyes, you may be buying an investment at a premium.

There's little question where the money is going, fueling momentum-driven gains across the emerging regions of the world. And it is exceptionally likely that investors will buy 15%-20% dips on emerging market funds, as faith in the reflation of the global industrial cycle strengthens and as more money comes off the sidelines.

The question is, should investors put any faith in the Morningstar fair value concept? If so, we're talking about China garnering a bear-sized premium, while the overall emerging markets would need to fall roughly 13% to be considered "fairly valued."

With standard deviations at the furthest point out on the risk scale, a 20% pullback for China's PGJ or a 13% correction for EEM or even a 6.5% correction for Latin America may not be bad at all. In fact, for investors who have been patiently waiting for an opportunity to buy at lower prices, it may be desirable to see momentum give way to profit taking.

If you'd like to learn more about ETF investing… then tune into "In the Money With Gary Gordon." You can listen to the show "LIVE", via podcast or on your iPod.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.