At The Margin

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You’ve probably heard the talk making the rounds these days that margin debt is today as high as anything we have seen since 2007. In nominal terms, that’s exactly correct. So, is it really a reflection of “animal spirits” that are too highly elevated? After all, isn’t this exactly what Bernanke and friends wanted to have happen as the endgame for all the QE iterations? By the way, it was reported last week that in private meetings Mr. Bernanke again sees no asset bubbles at the current time. Thank heavens as his historic track record calling and recognizing bubbles has been so spot on, right? But this discussion is not about the Fed’s current most excellent adventure.

What I hope is more important than reviewing nominal dollar margin debt is to look at rates of change, both present and historical. As quick backdrop, history teaches us that the largest year over year rates of change in margin debt expansion usually come right after important equity market lows. Simply common sense in that margin debt usually drops off quite hard during meaningful bear markets, so it’s pretty darn easy to see very high annual rates of change after these types of declines. This is exactly what you see in the early 1970’s, after the mid ‘70’s market low, post the early 1980’s low and again in the early 1990’s.

But as we move through the prior decade of the 2000’s, this historical rhythm essentially reversed. We saw the highest annual rate of change highs in margin debt expansion in the late 1990’s and right at the 2007 double equity price peaks. Now that’s the expansion of animal spirits moving right into very important highs. Those two spikes right into market highs follow meaningful Fed sponsored monetary ease. The chart below looks at the year over year rate of change in margin debt alongside the price rhythm of the S&P 500 itself.

Certainly what we are seeing right now is not a rate of change spike peak in margin debt – far from it. In fact, wildly enough in the current cycle since 2009, we have seen successive declining peaks in annual margin debt rate of change – the current being the lowest rate of change peak at new S&P successive highs. Is this some type of divergence? To be honest, I only wish I knew. All I can do for now is look back historically and see a similar rhythm with what occurred in the 1970’s – a period of a very long term bear for equities that essentially moved sideways for close to a decade and a half. So for the moment the year over year rate of change rhythm in margin debt does not look like it did at all at the 2000 and 2007 very important equity peaks. Alternatively it resembles the rhythm of what occurred moving into the termination of the 1966-1982 secular bear.

spx vs. margin debt 1970 to 2013

Just a quick comment before moving ahead. We need to remember that the character of leverage in the equity market has changed over the years. In prior decades individual investors partook of margin quite liberally. But in today’s more institutionalized world, leverage comes in many different forms that cannot necessarily be categorized as “margin debt”, per se, in the numbers you see above. So there is some difficulty in historical comparatives. What you see above does not necessarily mean leverage is not a meaningful issue. It’s just that within the strict definition of margin debt as it is recorded and calculated, recent rates of change are nowhere even close to “off the charts”. If clear data on hedge, partnership, etc. leverage being employed in the equity market were publicly available and incorporated into the numbers above, the picture may look very different. Just something to keep in mind.

Alternatively, if we shorten up the view a bit and look at more high frequency month over month time frame rate of change in margin debt balances, we do see a recent rate of change spike that has only occurred five times in what is close to two decades. The prior dates were not necessarily fun times to be fully invested and complacent. And wouldn’t you know it, the last meaningful spike came… the exact month the Fed announced QE3. Was this short term animal spirits in spades? Or did investors take indefinite and unlimited QE3 as the ultimate Bernanke put? Time will tell.

nyse margin debt outstanding 1994 to present

As maybe a final piece of perspective, I find it very useful to look at margin debt as a percentage of the total value of the US equity market itself. But again, we need to be careful. First, the margin debt numbers come directly from the NYSE. I’ve used the historical Fed Flow of Funds numbers for total equity market value in the calculation to create the chart below. Maybe just a total coincidence for all I know, but the current ratio of margin debt to total equity capitalization just happens to be the long term average of experience from 1959 to present. Again, certainly not an outlier or an extreme.

margin debt capitalization 1959 to 2013

The only note of caution I’d leave you with is this. As you can see, the historic high came back in the mid-1980’s leading toward the 1987 crash period. And although the highs leading into the 2000 and 2007 important equity peaks were well above the long term average of experience, they did not approach or exceed that mid-1980’s high. In the clarity of hindsight, the very meaningful drop in equities in the prior cycle, and especially in the latter half of 2008, was in very good part driven by hedge liquidation.  In other words, leverage liquidation. We never saw this as a warning in the margin debt numbers as so much alternative asset leverage is never seen in the simplistic NYSE margin numbers.

As with so many historic indicators, change in the character of the financial markets over the last few decades has forced us as investors to change just how we interpret data, including the rhythmic rate of change movement in margin debt. Bottom line being that although nominal dollar margin debt has “broken out” to a new high for the current cycle, rate of change movement suggests animal spirits are not yet out of hand.

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About Brian Pretti CFA