THE FINANCING PYRAMID
Last week’s volatile action in the markets began to show some of the confusion that market participants are experiencing. Much of this confusion has been due to QE2 and the uncertainty regarding the end of the program. As we near the end of the program it’s difficult to ascertain exactly what QE2 has done. One thing is clear, however – QE2 has contributed to significant speculation in markets. This has been most apparent in the continuing surge in margin debt. I discussed this a few weeks:
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.”
Late last week the CIO of a boutique investment firm emailed me with some superb thoughts on the increasing debt in financial markets. He referred to the current environment as the “financial pyramid”:
“If this financing pyramid is near correct, then prices are simply a reflection of leverage rather than an inflation of money. If there is only speculative non-bank horizontal money, then whatever commodity (non-monetary) inflation exists must be transitory, because it relies on a permanent Ponzi condition (leveraged commodities holdings that depend on prices being higher to satisfy liabilities). So it seems that the central banks distortions of the last several years are creating some imbalances that are unintended and unwanted, which is to increase speculative volatility in things like oil, which goes from $40 to $150 to $50 to $130 over and over. Paper profits change accounts but the real economy is not theoretically affected, except that it is held hostage to this casino game of rapidly changing prices for basic materials and necessities that businesses and consumers use to make decisions. So the economy is in actuality disrupted by the casino, the casino creates no net wealth, and everyone is worse off as this charade continues.”
That’s one of the best summaries of the effects of QE2 I have yet seen. Most interestingly, Ben Bernanke is likely to be right about one thing – the increases in commodity prices are likely to be transitory and the continual fear mongering over high inflation is likely to be wrong. On the other hand, with growth having peaked when QE2 began, I think it’s important that policy makers begin to ask whether QE2 isn’t having a negative impact on the economy. If the air comes out of the financing pyramid I think that question will likely answer itself. Hopefully, the Fed won’t respond to any market or economic downside with more of the same misguided medicine.
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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24 Comments
Lol at last sentence. You know exactly what they will do. The only thing they know how. We are now in a perpetual cycle until a person like V olcker 2.0 shows up and with Easy Yellen set to supersede Bernanke we’re talkinf 2030s before any chance of a non serial bubble blower running the monetary policy.
Let’s see:
1) QE’s only misled speculators to you-know-what
2) when they catch on, who cares if the FED repeats fiat irrelevance?
Everyone should know that the FED has no way to boost aggregate demand. Maybe they’ll throw Timmie under the bus, but who cares? All that will matter is whether we demand that people with both domain knowledge & spine as a prerequisite for public office. Historically, that takes 2-to-3 election cycles and/or generational turnover.
We all know how they’ll respond to a market decline or potential economic downturn. They’ll really crank up the QE3. Bernanke thinks it’s helping. And it won’t be until oil hits $200 that he realizes he’s sunk the entire global economy.
Interesting as it looks like when margin debt goes parabolic it has typically indicated a major market top; would be interested to see if those tops had a certain annualized margin debt rate of growth that was similar and similarly, if they resembled the rate it looks like we’re putting up now…
I tend to agree however I see one huge outlier data point – corporate profits. If QE2 has inflated input costs more so than it has boosted end-demand then I would expect to see corporate profits get squeezed. Quite the contrary – we are near record levels. There must be enough end demand to more than make up for the the QE2 inflationary effect. I’ve yet to see Fed critics really address this point. What are your thoughts?
effem,
Good point. Corporate profits can be explained by a couple of things, I think: 1) they have managed inventories and labor well and are enjoying profit margins about 40-50% above normal; 2) global demand has helped multi-national large corporations export; and 3) the large federal deficit is adding to private savings and allowing for a smoother deleveraging that maintains some demand beyond what would be indicated by the paltry level of wages alone.
Corporate profits right now are because of rising exports. If foreign inflation rises faster and demand slows overseas …. . All this just means that the US locomotive of aggregate demand now has multiple little loco children running around, delaying but not forestalling deflation.
Another few important factors regarding corporate profits:
– the huge layoffs in recent years have boosted productivity at the expense of the little guy
– the FED’s artificial finance market is allowing companies to undertake capital management initiatives which are helping EPS numbers – i.e. refinance debt at much lower rates and/or use cheap debt to buy back shares (look at a lot of corporate balance sheets – leverage has risen, which is a worry)
You have to wonder how much longer these factors can continue – surely we must be near “maximum efficiency” in terms of employee levels and balance sheets
Well said, thank you for sharing.
Just lower margin requirements for an added “wealth effect”. What could possibly go wrong?
“then prices are simply a reflection of leverage rather than an inflation of money”
How is margin leverage NOT an inflation of money?
I hate this chart! Look how much money is being poured into the gambler’s accounts. I think this means these gamblers control ten times this much commodity (via futures) and/or stock (via puts and calls). I’ve posted this problem before. We are allowing businesses in the world to be torn apart by volatility. This is not helping anyone. I think those folks trading futures, puts and calls should be required to actually put up 50% of the value rather than borrowing a measly 1%. If this were the case then the actual producers and buyers would still be able to hedge their business, but the gamblers would be taken out of this.
Markets doing what they do best Dennis – taking illogical easy money policies that cannot fix the predicament we’re in to their illogical extreme – rampant specualtion in financial assets of all kinds.
I’ve always been amused by the talk that capitalism failed in the housing bubble run-up and during the crisis – just like this margin debt chart, I think it worked all too well – profit seeking capitalists were being incentivized to take as extreme risks as possible and that is precisely what they did, to perfection!
Dennis, if they do what you want the emperor appears naked again. The government and TBTF’s are not ready to see this. I do not think the main street or real businesses are the point of the leverage excersize
I forgot to mention currency and bond speculation (via puts and calls), that damage whole nations causing millions of folks to lose their jobs (if they had one). The gamblers lose what they put on the table but a company guessing wrong one time on their commodity purchase can bankrupt them in one day. One G-7 meeting could put an end to this madness. Since we are talking about “pragmatic capitalism”, and seeing how it has “progressed” over the last few decades, we need to see actual studies of the negative impact of this has had so we have some arguments why this needs to be the number one priority. The advent of computer trading has made the speculation process a danger to the world way worse than anything else I can think of.
Wsj,
Exactly. Standard commercial bank debt may not be exploding due to QE, but margin debt is. Ie, expanding money supply. No different than real estate bubble, just different “collateral”.
This was ever the Fed’s intent – to blow another asset bubble.
Hmmm, seeing as margin debt is lower than during the RE bubble, I think that is a bit of a stretch. Much, much less overall credit.
Of course as for real estate you didn’t need to put any money down. Luckily (or sadly?) this is not the case for margin.
Wonder what the chart has done since end of 3rd qtr 2010 ?
Does seem like we have an obsession with debt.
does anyone know where the latest info on debit balances can be looked up online?
Ok, according to this graph it looks like 2007:
http://www.elliottwavemarketservice.com/2011/05/nyse-margin-debt-highest-since-feb-08/
Here’s some more:
http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=3153&category=8
http://online.wsj.com/article/SB10001424052748704604704576221090930998046.html
http://www.marketoracle.co.uk/Article27706.html
http://www.theglobeandmail.com/globe-investor/markets/markets-blog/speculation-alert-margin-debt-at-a-peak/article1920284/
excellent, thanks!
Hi Cullen,
can you tell me who the CIO of that boutique firm was or at least the name of the firm? Thank you
No can do. Sorry. I keep emails confidential.