SURGING MARGIN DEBT AND THE INSTABILITY QE2 HAS CREATED

As we noted earlier this year, margin debt has tended to correlate fairly closely with the direction of the equity market.  And according to the latest data from the NYSE, margin debt continues to move higher.  In an effort to ride the coattails of the Fed and QE2’s “can’t lose” environment, investors have dipped into their borrowings to buy equities.  David Rosenberg highlights the speculative fervor that this now represents.  Current levels of margin debt are now consistent with the Nasdaq bubble and just shy of the levels seen before the credit crisis (via Gluskin Sheff):

“If there is one sure way to tell that the Fed has managed to create and nurture a speculative-led rally in the equity market, look no further than what is happening to investor-based leverage growth – it’s exploding off the page.  Yes, that’s right.  Debit balances at margin accounts skyrocketed $20.7 billion in February.  Only two other times historically have we seen leverage rise so much so fast and both times it was during a manic phase – during the tech bubble of the late 1990s and the credit bubble just a short four years ago.

To put that $20.7 billion incremental leverage in on month into proper perspective, it represents a 7.2% jump, or an increase of no less than 129% at an annual rate.  And, it’s not just February – the rising use of credit to buy stocks has zoomed ahead at a 64% annual rate in the past three months.  If and when the markets breaks, the problem in trying to contain the downside momentum is that there are no short left to cover, which actually helps as a shock absorber.  The Fed has successfully cleaned out the short community, and the extent to which we see margins being called away may very well accentuate and downside pressure…if it should come.”

The results from QE2 are beginning to look fairly clear.  Not only does this program appear to have done very little to help the real economy, but it appears to have sparked a speculative move in risk assets that creates a disturbing level of instability.

Source: Gluskin Sheff

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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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