Deja Vu on Margin Debt – 2013 Repeats 1999 & 2007?

Deutsche Bank has a monster note out on margin debt that has been making the rounds.  The conclusion of the note is rather simple – today’s euphoric borrowing on margin to buy stocks is reminiscent of past bubbly equity market periods (see here for more).  The note reviews commentary from the 1999 & 2007 periods and compares it to what’s being said today.  They found some eerie similarities:

We prepared a collection of press articles which were published around the key events during the past financial crises as displayed in Figure 2 on page 2 above. Our key finding is straight forward. Irrespective of the publishing date, the articles read alike throughout the two major crisis periods, i.e. the “new technologies market equity bubble” (1999-00) and the “Great/Global Financial Crisis” (2007-08) (see Figure 6 on page 5 and Figure 7 on page 6). Most interestingly, litrally the same content can be found in todays’ press as displayed in Figure 8 on page 7). Universal phrases include:

“A rising stock market encouraged more investors to go into debt to buy stocks, sending margin debt levels past their all-time high”.

“The National Association of Securities Dealers (NASD) has asked members to review their lending requirements in a sign of increasing concern that rising levels of margin debt could exacerbate a stock market plunch.”

“The Fed is concerned about a sharp rise in margin debt but has been unwilling to attack stock market speculation as high levels of leverage do not necessarily translate into high risk. The last time the Fed adjusted the margin rules was in 1974, when when it reduced the down payment required for stocks to 50 percent of the purchase price, from 65 percent.” […] “The Fed should return to its pre-1974 policy of actively changing margin requirements in response to stock market speculation”.

“High margin debts show the effect of over-leveraging and mispricing of risk”.

“The movements in stocks cause brokerages to stop allowing customers to buy some of the volatile stocks on margin or require clients to put up more cash.”

“Either the market rises dramatically to make those loans good or in any down move there is tremendous selling pressure”.

“Until recently, most investors ignored red flags raised by regulators”.

Why is margin debt dangerous?  

Leverage is dangerous for many reasons, but the dangers of an excessively levered market are really rather simple to understand.  As DB says, it creates an environment that can lead to a disorderly unwinding of excessive risk:

“Margin debt can be described as a tool used by stock speculators to borrow money from brokerages to buy more stock than they could otherwise afford on their own. These loans are collateralized by stock holdings, so when the market goes south, investors are either required to inject more cash/assets or become forced to sell immediately to pay off their loans – sometimes leading to mass pullouts or crashes.”

Margin debt creates the sort of unstable environment that makes a snowball effect much more likely than it would be in an environment without margin debt.  If you recall 2008 you likely remember hearing about how many fund managers were “forced liquidators” of portfolios.  That was, in large part, due to the excessive leverage.

But there’s a double whammy effect with leverage.  Not only are the regulators likely to force you out of positions that go heavily against you, but from a psychological perspective it creates a much more fragile environment.  If you’ve ever been short a stock you know what I mean.  It’s one thing to own the stock outright in a long position.  It’s a whole different mentality to borrow a position knowing that you’re PAYING to own the position.  That creates a finite trading period and a sense of uneasiness that makes a levered trade much more different than outright ownership.  Being on leverage is kind of like a teenager who borrows his/her mother’s car versus driving his/her own car. You don’t want to crash your own car, but you really don’t want to crash your mother’s car (because it’s not yours, there’s more on the line!).

All of this is interesting not only from the perspective of the investment world, but also from the perspective of the monetary system.  I sincerely believe that this environment is due, in large part, to the Bernanke Put and the idea that you “can’t lose” by owning risk assets because the Fed will put a floor under the markets no matter what.  This borrowing to own more stocks is a case of what is called a disaggregation of credit.  It is, in essence, an unproductive use of credit that provides no real benefit to the real economy, but potentially adds a destabilizing element that rewards gamblers and no one else.  As I’ve explained before, this is the element of QE that I simply despise.  As a market practioner I know, for a fact, that this mentality influences price action and has the potential to both help (on the upside) and hurt (on the downside) the economy.  I see no need to encourage such behavior and I think that’s what the Fed is doing via QE.  I think it’s irresponsible and very poor risk management – something that all banks, even central banks, could improve upon.

So, are we in a 2007 or 2000 type environment?  Yes.  I would say we are given that the data is confirming the same sort of market trends and debt trends.  But the question is what’s the trigger?  The market is kind of like a Jenga set at this stage in the cycle.  Everyone knows it can probably be toppled by the wrong move.  But that move might not come this year, nexy year or in the next few years.  As Keynes said, “Markets can remain irrational a lot longer than you and I can remain solvent.”

margin_debt

 (NYSE Margin Debt vs S&P 500)

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. No one knows what the trigger event is. But it’s out there. It’s always out there.

  2. Here’s a link to a reposting of the Deutsche Bank article with some nice graphs:

    http://softcurrencyeconomics.com/2013/07/26/margin-debt-a-potential-sign-of-trouble/

    I don’t understand this:

    “total investor net worth just hit a record low since 2000 at USD106bn.”

    The accompanying graph shows investor net worth is currently at NEGATIVE USD106bn. I think that’s what it shows. I’m not sure what “-ive Net Worth” means on Figure 1. (I did finally figure out that “lhs” means left-hand scale).

  3. I use Interactive Brokers (IB) and for years they have been advertising that you can borrow a million dollars for about 1.2% on margin and invest in high yielding dividends.

    So buying stocks with money you don’t have is definitely scary – the margin calls can be automatic especially if the underlying collateral declines as well. IB will not let a position go against you and will sell it automatically at a certain point.

    I think Mauldin would call Margin Debt a “Finger of Instability”.

    • Yes I use IB as well. Once you get to the 100K “portfolio margin” requirements you can get quite levered up. Back in 09, I got levered up on Junk Bonds that were paying around 12%. With the leverage, I was getting +20% yield and with lots of capital appreciation ( which accounted for the bulk of my profit) .

  4. Totally agree on the points in this OP. What is the trigger event indeed? That’s the million dollar question. GDP miss ? Unemployment far below expectations? Layoff announcements. Externality such as violence in the middle east? Terror attack? Seems like even with economic indicators missing, the Fed will make some pro-QE announcement ( the Bernanke Put) and the market will recover.

    Seems to me that back in 08 the trigger was the crude oil sell-off which brought down the commodity complex and then Bear-Sterns etc which devastated equities.

    The crude oil sell-off happened when congress started making inquiries into excessive speculation( vs Hedging) in oil futures markets.

  5. I’m amazed at how many of the smaller cap stocks I follow have gone vertical over the last 6/12/18 months. The Russell 2K is definitely frothy here.

    I see where Chanos mentioned that there are more stocks trading at over 3 times book value right now than there were in March of 2000. I think that while noteworthy, it’s more indicative of how cheap ‘old economy’ stocks were in March of 2000 since the rest of the market was in the stratosphere.

  6. You also need high leverage in the corporate sector. I haven’t seen any recent numbers from S&P for SP500, whether the large corps have releveraged up net debt to ebitda .. anyone seen a recent chart?

  7. Really appreciate your efforts with this website.
    One comment on this post: Wish that “disaggregation of credit” or such technical terms are replaced with simpler explanations. Isn’t it really simply the action of all credit users, including individuals, companies, and governmental entities? Anyway, just a minor point on a post that I found to be an extremely valuable input for risk management (equity exposure).

  8. The thing that really pisses me off is, I use 20% trailing stops on every stock I own, however in my 401k (money I might actually need one day) I can’t use a trailing stop. I’m ten years out before retirement, the system seems rigged against me. Also who ever said end of QE as a trigger, in my opinion, when QE ends, money will flow out of bonds and go somewhere. Maybe equities? Maybe gold? I’m not sure where it will go. However It might not pop the bubble.