Danger Signals—Yellow Light

I am an admirer of Alan Greenspan. But, I am also a bit skeptical of comments by anyone who survives a lifetime career working in the political environment of Washington DC.  Alan has written a new book telling us what he has “learned” during his period of reflection after retirement.  In a recent interview, he made this statement about bubbles: “But a bubble in and of itself doesn't give you a crisis. It's turning out to be bubbles with (debt) leverage." He also said, "If you're looking at the distribution of outcomes, fear is hugely more important than euphoria or greed," Greenspan told CNBC. "Bubbles go up very slowing and then they go bang."

 Admittedly, my career as an economist is not as long or as storied as Alan’s, but I guess Alan and I disagree about the definition of a “bubble”. It is my strong belief that a “bubble” is caused by (debt) leverage.  And, it is the spending of money that people don’t have that creates the fear that ultimately causes the bubble to pop.

Without excessive debt, asset prices can rise significantly, but they seldom crash. Think of a rocket versus an airplane.  Rockets rise rapidly until they run out of fuel—then they crash. Airplanes rise too, but even when they run out of fuel, they can still glide back to the surface.  Bubbles are like rockets and the required rocket fuel is excessive debt.

Everyone pretty well understands that the 2008 crisis was caused by excess debt related to housing. Less well understood is that there are people who speculate in the stock market using borrowed money. It’s called “margin”.  http://en.wikipedia.org/wiki/Margin_(finance)

Many people believe the stock market crash of 1929 was caused by excessive margin debt with some borrowing as much as 90% of the stock’s price.  After the crash, the Fed has limited margin to a maximum of 50% of the stock’s price—still a very risky investment strategy.

You will see from the figure that high margin debt rises and falls with the rise and fall of stock markets.  Is it a leading or trailing indicator?   I think it is a leading indicator---people using increasing amounts of money they don’t have to buy stocks causes stock prices to rise beyond the “reasonable” price that a “cash” buyer would pay based on the investment value of the stock. 

Speculators use margin to increase their short term profits—it is leverage—more “lift” with less effort.  But, they know it is risky.  At the slightest sign that prices are falling---they ALL run for the door at the same time, trying to sell and protect their gains or to avoid huge losses.

 Rising margin debt in 2013, fueled by Fed Quantitative Easing pretty much explains the exceptional performance of the S&P500 this year. Prices have now risen beyond the “reasonable” price that a “cash” buyer would pay based on the investment value of the stock for many stocks.   

If you are a “cash” buyer/investor, then it is not necessarily a time to sell, but it is certainly a time where prudence calls for caution when it comes to buying most stocks. (Sort of like 2007 when home prices had risen to a high level because of excess borrowing by buyers spending money that they did not have and could not pay back—not necessarily a time to sell your home, but not a very good time to be buying a new one!) We are currently at record levels of margin debt--every major correction in the past (1929, 2001, 2008)  has been preceded by record levels of margin debt. This time might be different because interest rates are so low, but although history does not repeat itself--it does tend to rhyme. High margin debt is a warning signal to pay attention--there is a potentially dangerous situation forming.

Keep in mind that investors don’t typically own the “market” but rather a unique collection of specific securities. Bubbles tend to cause all stocks to rise, but most of the “froth” shows up in only certain stocks and “hot” sectors.  e.g. Google and Amazon.  Many “solid” companies are still not significantly overvalued and it is likely that quality stocks are still very good long term investments.  (For example, home prices in Las Vegas rose to ridiculous levels and crashed in 2009, but home prices in like York, PA, Texas and Tennessee did not rise or fall as much.)

We do advise clients to hold a higher than average “cash=short term fixed income” balance in anticipation of buying opportunities that present during future market downturns.

 

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.