Previously, I wrote about three different numbers pointing to an imminent market decline. Imminent here means within the next 12 months (but I wouldn’t be surprised if it happened in one month).
After writing it, I thought of two more pieces of data that help tell the story of an over-leveraged market ready to decline.
Sharp Increase in Margin Debt
Margin debt is the loan an investor will take to juice up their returns. For example, if you think stock A is going up 10%, and you have $100, you take out a loan for another $100 and invest it, too. The stock goes up 10%, and now you’ve made $20 instead of just $10. You pay off the loan, with $1 in interest, netting out $19.
This isn’t a new investing tool. It’s as old as hedge funds themselves. What’s noteworthy is the percentage increase in margin debt in the last year.
I totally cherry-picked this figure to make it as visually clear the potential level of risk we may be at. Click the source above to read the full report, and of course, research and verify the margin debt levels yourself via FINRA. As always, none of this is investment advice, so take care to verify (or disagree) with anything I’m saying.
More context: as a percentage, the rise isn’t as dramatic. However, it is right in line with previous margin debt percentages changes that preceded a market contraction. The fact that we are “overdue” for a correction (based on the meme idea that markets go bearish every seven years) is because we have been buoyed by cheap credit. We were seemingly due for a correction at the start of COVID, but relief programs like PPP, cheap loans from the Fed, and the purchasing of bad debt has held the it all back.
Speaking of cheap credit…
Record Low Interest Rates
The interest rate is the OG mechanism for central banks to regulate their economies. When the market is sluggish, the interest rate (the cost to borrow money) is lowered, making it easier to get loans and kickstart business ventures. When the market is bloated, the interest rate is raised to put pressure on businesses to actually create value with their loans, shaking out weak ventures living off credit and not actually adding value.
Currently, the Fed Funds Rate is 0.06%. This is literally an all-time record low. Notice, that number doesn’t say 6% or 0.6%. It’s 0.06%. Not even 1/10th of one percent. Credit has literally never been this cheap.
It should be no wonder why margin debt is crazy high. When the Fed Funds rate is low, big banks can borrow cheaply from the Fed. They then make loans out to other banks and investors at appropriately cheaper rates. It’s easier than every to borrow when the cost of doing so is so low.
Going back to our example of borrowing to invest $100, that would be like paying 6¢ of interest on $100. Who wouldn’t take that deal?
What would pull the rug out from under this whole scheme? Maybe if the Fed had to raise rates…
“Nobody’s gonna say it?”
Why in the world would the Fed pull out the bottom block in the Jenga stack? I believe they wouldn’t, based on the crazy behavior and loans they’ve been handing out this year. That’s the whole origin of the money printer go brrrr meme.
The current Treasury Secretary, Janet Yellen, happens to be a former head of the Fed. So it makes sense she’ll probably still be thinking in terms of “manage the economy” and “let’s not crash the market with no survivors.”
Note: she’s talking about the Fed Funds rate. She doesn’t have any control over that (anymore). But she does have loose influence to leverage. She’s giving them (and investors) a signal to say “hey, this ride can’t go on forever or it’ll only get worse once something inevitably breaks.”
Put this in another way: imagine you’re out in public and your child is screaming. Someone else walks by and says “looks like that child could use a spanking.” I mean, yes, but it’s pretty rude of them to try and tell you how to parent. Unless you’re refusing to discipline your child, in which case, you probably do need to be told off.
This is Yellen telling someone else to do their job because they’re not doing it.
When the Fed finally raises rates, margin debt gets harder to come by. Interest on the margin rises. Investors start to deleverage, use less margin. The sooner this happens, the smoother the deleveraging. The longer it goes on, the sharper the decline because instead of naturally reducing their risk, investors will maximize it until some bad piece of news causes one of their investments to decline.
Then they get margin called, sell off their shares to meet the margin call, further declining the price, triggering more margin calls, eventually leading to a massive decline across sectors. It’s the story of every market collapse.
Seek shelter. #NotFinancialAdvice