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2018: The Year Of The Margin Call

Analysts disagree about which indicator is best for calling market tops, but the easiest to understand — and the most tragic — is probably margin debt.

This is money borrowed by (usually individual or “retail”) investors against their existing stocks to buy more stocks. Investors tend to do this when markets are rising and using leverage seems like an effortless way turbocharge their gains. But eventually the market turns down, leaving stock portfolios insufficient to cover related margin debt and generating “margin calls” in which brokers demand more money and/or start liquidating customer portfolios. This sends the market down sharply and indiscriminately, as fairly-valued babies are dumped along with overvalued bathwater. The result: a quick, brutal bear market.

Margin debt hit record highs several years ago and has just kept on going. From yesterday’s Wall Street Journal:

Investors’ Zeal to Buy Stocks With Debt Leaves Markets Vulnerable

Investors borrowing record sums to bet on stocks exacerbated this month’s selloff, after they were hit with calls to reduce those obligations and forced to sell shares to raise cash.

If that debt, known as margin loans, continues to rise at the current pace, analysts warn that big selloffs and sudden bouts of volatility in the stock market could become more commonplace.

Retail and institutional investors have borrowed a record $642.8 billion against their portfolios, according to the Financial Industry Regulatory Authority, as they try to pocket bigger gains by ramping up their exposure to stocks.

So-called net margin debt was worth 1.31% of the total value of the New York Stock Exchange last year, according to Goldman Sachs data stretching back to 1980, eclipsing the previous peak of 1.27% reached in the buildup to the tech bubble in 2000.

Lending against securities is a key profit center for brokerages, as firms charge interest on the money that is used and say they have found they better retain clients who take on the debt. These loans can also factor into brokers’ compensation, incentivizing many to extend money to clients regardless of whether they need it or not.

Margin debt has been on the rise for years and is generally considered a gauge of investor confidence. The long-running stock rally has helped push debt levels higher since investors tend to be more willing to take loans against investments that are rising in value. However, it can also precipitate a steep market downturn as it did before the burst of the dot-com bubble and the financial crisis of 2008.

The growing loan balances have caught the attention of Wall Street’s watchdog. Finra in January published an investor alert after the total value of margin loans broke $600 billion for the first time, saying investors may be underestimating the risks of trading on margin and may not understand how margin calls work.

Many of the hardest-hit investors were those who had used exchange-traded products to wager that low volatility would persist and stock prices would remain stable.

Harvey Hajiyan, a 35-year-old financial adviser who lives in Toronto and has been investing for more than a decade, assumed stocks would continue to grind higher this year, similar to the gains the Dow and the S&P 500 had posted for much of the past two years without a pullback.

“All of the strategists agreed the market would go up,” said Mr. Hajiyan.

At the end of January, he placed an ill-timed bet and used only margin to fund a large position in the ProShares Short VIX Short-Term Futures exchange-traded fund (SVXY), which rises as long as stock prices remain stable. When the S&P 500 fell into correction territory to erase one of its best starts in years, Mr. Hajiyan’s investment in the ProShares fund tracking expected market swings was nearly wiped out, forcing him to liquidate hundreds of thousands of dollars of securities to answer the margin call.

“I was in denial,” said Mr. Hajiyan after he realized he lost about 600,000 Canadian dollars (US$472,260) worth of his C$1.1 million investment portfolio.

Despite losing a sizable portion of his wealth, Mr. Hajiyan says the experience hasn’t soured him on using margin debt. “If I wasn’t using margin, I wouldn’t be at this level,” Mr. Hajiyan said of his profits before the pullback. “As my money grows, I’ll limit the amount of margin I use.”

Why This Matters
“So-called net margin debt was worth 1.31% of the total value of the New York Stock Exchange last year, according to Goldman Sachs data stretching back to 1980, eclipsing the previous peak of 1.27% reached in the buildup to the tech bubble in 2000.”

When an indicator exceeds its dot-com bubble extreme, it’s in mania territory. The reason equities seem relatively sedate this time around is that they’re just part of a much broader bubble. Bonds around the world are an historic bubble – one that may be starting to burst as interest rates rise. Real estate prices in trophy cities have exceeded their 2007 extremes. Debt levels in the developed world (and China) have blown through their previous cyclical peaks. And of course cryptocurrencies are generating dot-com level excitement and fear of missing out. This “everything bubble” is completely unprecedented.

“The growing loan balances have caught the attention of Wall Street’s watchdog. Finra in January published an investor alert after the total value of margin loans broke $600 billion for the first time, saying investors may be underestimating the risks of trading on margin and may not understand how margin calls work.”

The “may not understand” part is, as usual at market peaks, an understatement. Towards the end of a long cycle like the current one, a whole new generation of investors emerges who, never having experienced falling prices, eagerly embrace tools that magnify their genius. This is a rite of passage that all investors have to go through on their way to cautious middle age, but with each new debt binge the stakes get higher. Now we’re talking total wipeout rather than painful but survivable life lesson, and systemic collapse rather than one or two bad years.

 

Emigrate While You Still Can

27 thoughts on "2018: The Year Of The Margin Call"

    1. Also:
      “Nobody ever lost money taking a profit.”
      – Bernard Baruch
      brainyquote.com/

  1. The only problem with this analysis is a handful of analysts still think this market is bound to drop. That means it still has a way to go.

    I’m waiting for “Mish” and a few others to capitulate and finally realize that all the nay-saying logic about debt and unsustainabilities are totally misguided.

    Can’t you see that all the economic indicators are positive? Don’t fight the Fed. Interest rates are going up because the global economy has turned the corner. DOW 36,000 baby!

    1. No one really knows how long this can last but I gurantee you that the crash or burst is planned and the ensuing chaos anywhere there is a large and dependent population like New York, Detroit(well I guess Detroit is already ripping itself apart just like Chicago), San Diego, etc etc. NEW GREAT DEPRESSION+MODERN AND COMMONLY OWNED FIREARMS= Pray to god you don’t find your butt in an American, Mexican or FREEZING Canadian City when everything goes to hell.

    2. If everyone knows that “all the economic indicators are positive” then everyone has already built that prospect into their stock prices in anticipation, and there is no upside left. Probably.

    3. Bruce lee, that is what they (the majority main stream media and analysts) are saying and what was said all the way up to the 1929 crash. It’s only the contrarians that are many to us because we concentrate on them all the time, are giving the correct warning we are in an everything bubble and load up on what does good then, ie gold, oil, tangibles and survival supplies, as safe haven, before it happens. The safe haven before it happens is the everything bubble, of equities, bonds, real estate and liquidity still be there in money printing expected again. More debt and money printing coming back when collapses. But it can’t work a second time since are so close to zero interest rates it won’t take long to get to the screaming objectionable by all, negative interest rates, and paying banks for holding our money. Ever losing principle on it.

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