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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Comments

  1. Deflationary collapse dead ahead,all vertical charts will be completely reversed and magnified by the lack of shorts in the market.Margin calls will just be the icing on the cake.

  2. We are very close to the turning point in all markets. Commodities, Equities, Bonds will all get sold. The US Dollar will rally like 2008 on roids…. Buckle Up!

  3. The FED is not fighting against a 30′-like deflationary problem… There are creating the 28-29-like bubble….

  4. Not yet. There is plenty more to go. In fact, this will be the best part of the run in terms of a pure price vs. time look-through, especially for commodities. The current pull-back will be your last, great opportunity to buy anything with a quote into June/Fall 11…

  5. Not for the faint of heart. I think mine skipped a beat. Been mostly cash for a few weeks. But Obama has caved on raising debt ceiling so everything will be ‘ok’.

  6. Still struggling for that V shaped recovery. Houston, I think we got a dead cat bounce.

  7. bferro,

    on what do you base your timing?? I think we all agree this will not end well, (just got done perusing TPC’s paul ryan rant and comments) but the timing? you seem to feel that QEII effects will be picked up by some other program (QEIII?? I would doubt politically possible). So, my gut would say things crash before summer…

    Always interested in your perspective,

    rhp

  8. Cullen,

    Interesting but I can’t help wonder the relevance of margin balances against a more more sophisticated investing backdrop. In other words, what is the outstanding margin as a percentage of the assets they are margined against?

    Perhaps i am looking for an inflation adjusted figure?

  9. It’s probably impossible to know but this type of analysis would be much more interesting to me if total portfolio gearing was available as well.

  10. Oops, B B beat me to my point by an entire day. That’s what I get for falling behind on my ever growing list of TPC firefox tabs.

  11. Dear Cullen,

    I don’t want to raise your hackles about how nobody understands the US Monetary System, but to try to stick to an objective assessment about what the end to this “irrational exuberance” in the financial markets will be caused by.

    I was just reading a piece in FT Alphaville a moment ago (titled “The banking system – still broken” Posted by Tracy Alloway on Apr 12 12:38) and it brought to mind this piece on your blog.

    I quote from the FT Alphaville article as follows:-

    Here’s Dominic Konstam and Alex Li from Deutsche Bank:

    The $2 trillion in purchases have literally gone down a black hole. Required reserves haven’t been required to increase and the Fed reserve add has literally simply been hoarded as cash. Excess reserves at the Fed have subsequently soared by the same. In short, QE has been a spectacular disappointment in its impact on bank lending, whether via whole loans or securities. It was as if the banks conducted the very sterilization of QE that many thought perhaps the Fed should do to “contain” inflation expectations.

    (unable to copy their chart)

    If asset prices haven’t been increasing because of increased bank loans, then where have all those surging prices — in things like commodities or junk bonds — come from?

    Says Deutsche:

    Risky security prices have risen since QE but not Treasuries, the main instrument of QE2. Yet banks’ balance sheets have gone sideways. Effectively investors have marked asset prices higher and circumvented the banks. It is as if the first purchase by the Fed from an investor simply triggered a series of deposit for security switches through the investor base with banks never making an additional loan. This is consistent with a greater concern for risky asset post QE2 end, than Treasuries. The danger for investors is that they confuse the result of higher asset prices as reflecting excess liquidity rather than “irrational” exuberance given that actual liquidity (as broadly defined by the banking system) hasn’t gone up at all.

    END OF QUOTE (there was more in the article, but this gives the picture)

    Putting your piece and FT Alphavilles together, leaves the question – the banks must be funding the vast increase in leverage lending since QE2 began. Who else could or would fund it?

    Now to my main point about the future demise of the irrational exuberance in the financial markets: The Fed has effectively put a floor under the bond market, but not the other markets (which now all move as one market). When QE2 stops in June, the margin lending should stop in sync. If the private sector does not take over with the same confidence (at least $100 billion per month just to match QE2)- one major hiccup in the financial world could start a rush for the exit doors.

    I see this as a very important moment for the markets. Do you agree?

    Best wishes

    Michael Cullen

  12. I agree. The FRBNY-Treasury-Bank circle jerk will end. I have converted to cash. Better to be early than late. The FRBNY will end their treachery just in time for election season so their chosen one can be installed. Unfortunately my cash value will be eroded. I will wait for yields on treasuries to go to %15 then buy, buy, buy.

  13. A deflationary collapse…in earnest.

    The big question I have, is, will the price of silver and gold be affected and in what way?
    Up or down? I’ve been told it’s up for gold, but ironically, down for silver. Strange, but maybe it’s true.