According to NYSE’s April report, margin debt (ie monies borrowed to speculate in stocks) hit an all-time record level at $384bn, surpassing its prior high registered in 2007 – just before the great financial crisis unfolded…
The number is the latest evidence on how successful the FED has been in directing money to the equity market. With an economy growing just marginally, businesses continue to deleverage their balance sheets whilst on the whole, US households are still refraining from loading up on consumer debt. Conditions remain relatively weak and no one wants to take the cheap money to consume real good but, it seems, they are happy to do so in order to buy equities.
With the S&P 500 rising more than 15% YTD, on top of last year’s 13% appreciation, the seduction of easy capital returns (oh, if only it were that easy!) is all too easy to succumb to. Households are now returning to equities after the long 4 year bull run – precisely at the point that they should be taking chips off the table..
Credit is no longer being absorbed for productive purposes but rather, at the margin (in both sense!) for speculation. When that happens the financial and the real sectors start falling apart, and which sometimes is called…. a bubble.
The FED has now maintained its ZIRP policy for nearly 5 years and has thrown trillions of dollars at the US economy. For the ‘real’ economy however this has been as good as shooting rubber bullets at a bear. In the short-run, liquidity risks may stabilise but, in the long run, no real improvement on the productive side of the economy is likely to be seen but the risks of mid-late cycle, asset induced inflation is rising exponentially. Seen this way, monetary policy is a great instrument to manage liquidity risks and short-term imbalances but ineffective at targeting the real economy. If the jobless rate really drops to 6.5%, as is currently targeted by the FED, there is a high probability that the equity market could be even more artificially inflated and so when the FED looks to exit they could trigger the mother of all crashes and so reset the economy back to square one!
But, caution isn’t a word that the FED recognizes with current incumbent “Helicopter” Ben Bernanke. In looking at what a complete failure the more tempered QE policy was in Japan during the past 2 decades, the FED decided instead to go all in on aggressive monetary easing. As a result, no one sees risks in the equity market anymore and margin debt is at record levels on the NYSE. Speculators are at full strength. They feel their backs protected by the FED and they are willing to borrow to bet more. The problem is that peaks on margin debt have been associated with equity crashes as the chart below relays absolutely crystal clear…
Leverage can be used as a sentiment indicator because it is related to investor confidence. In fact, we would argue that it is the best investor sentiment indicator that there is – it sin’t their “mouth”, it’s their money.
When investors are more confident, they are willing to take on more credit. But, at the same time, the two prior peaks in NYSE margin debt preceded the peaks in the S&P 500 in the tech bubble in 2000 and in the housing bubble in 2007. So, it is time to ask the following question: Are we approaching a new top?
Only time will supply a proper answer to that question, but we can extrapolate some clues from the recent past. When everybody is extra-confident, demand for assets increase and so do prices. Margin trading allows for leverage which contribute to price demand even more. As the real economy lags behind, equity valuations start rising until the point is reached where they are unjustifiable. It only needs one spark to set off the crescendo of margin calls and as we have seen precisely in Japan in recent days. Tread carefully, very carefully.
In our new Titan Macro fund we are positioning via options for a market correction in certain indices (as we did in the Nikkei just over a week ago – and where have switched to a modest long now expecting a rebound to perhaps a double top), applying leverage judiciously and playing specific sectors where there is value and in which they would benefit from a market rout in fact. If you would like to participate in this then email MACRO to editor@spreadbetmagazine.com or visit our Titan website by clicking below to register your interest.