Stock Performance and Margin Debt

Pretty interesting data here from Charles Gave (via John Mauldin):

“I started in the fascinating business of trying to understand why markets go up and down in February 1971. The old money manager in the French bank which had hired me straightaway said: “Charles, you will never get rich in this business using other people’s money. Do NOT leverage your positions. Leverage might be all right for fellows who deal in real estate, but for those in stock markets, it only brings misery.”

Being young and smart (or so I thought), I assumed this advice could not conceivably apply to me. A few margin calls later, accompanied by quite a string of sleepless nights, and I came to realize that the old gentleman had a point.

Now that I am quite old myself and certainly not as smart as I thought I was in 1971, I find myself tracking the moves of the poor souls who believe they can leverage profitably. Then I do the opposite. This is why Charles the 70-year-old is watching what Charles the 30-year-old is doing—to do the reverse. Have a look at the graph.


The red line at the top is New York Stock Exchange margin debt as a multiple of US GDP per capita, the black line on the bottom pane is a ratio between US stocks and (government) bonds. It seems that the fellows using other people’s money to get rich have an uncanny ability to leverage up when shares become overvalued vs. bonds. They also seem to get most enthusiastic just before a recession, usually after a prolonged outperformance of equities against bonds.

They leverage in order to participate as much as possible in what looks like a free ride, with no downside risk. There are always a number of good reasons why the stock market cannot change direction. Take your pick: “technology has created a new type of economy,” or “house prices never go down,” or “we have recently discovered an infinite source of wealth called QE.” These reasons can be added to a long roster of other excuses such as, “I can get insurance against the next market decline” (1987) or “the Fed will never, ever allow for positive real rates to appear” (1979) or “oil prices cannot quadruple” (1974).”


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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. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • esb

    You forgot the best of all, “it’s a new paradigm.”

    This new paradign, the “allest” in Fed will work until the plug gets pulled and the Fed goes back (or attempts to go back) to being just all in.

    One body of opinion in the investment banking community is that the Fed has trapped itself into situation in which it will only be able to conduct policy in the future by modulating the rate of QE with short rates pretty much always held below 1%, unless it desires to precipitate an all asset markets crash.

    If ten year rates pop up another 1.2% we will have then wintessed the first in history 150% change in yield within a six month period.

    “But it’s off such a low base” you prattle.

    Well, you had better be right on that one.

  • Anon

    During 2008/2009 shorter yields were already zero and in fact briefly negative, so by your argument they already went up infinite times – so looking at the percentage increase is meaningless and silly.

    For interest rates it is the absolute percentage that matters.

  • QH

    Cullen, any opinion on Mauldin’s position that the market may be running out of steam?

  • Andrew P

    When I hear “new paradigm”, I think how many ways are there to pare a dime?

  • GRock

    Margin costs are a lot cheaper than in 2007. And when taken as a percent of GDP as in the first graph it certainly can go higher taking the market up with it. But will it?????

  • indignado

    High levels of margin debt + rising rates = interesting times… :-)

  • Old Dog

    Mauldin makes a ton of bucks spreading bad news that is either out of context or never comes to be.

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