The Bull Market's Still Built on Borrowed Money ... What Will Cause the Crash?
WHY YOU SHOULD CARE
Because your savings could be wiped out between morning coffee and lunch.
By Jeffrey Moore II
On Friday, February 2, 2018, U.S. equity markets hit the closing bell after suffering their worst weekly performance in two years. The soft patch followed a near parabolic ascent of markets extending back months and accelerating through January, so the bull market taking a breather was not terribly surprising or necessarily worrisome. After all, over the past couple of years these kinds of pullbacks consistently have been followed by higher highs.
As markets opened on Monday, February 5, though, they were not bouncing back. Instead, inflation concerns were continuing to drag on stocks as spiking interest rates persisted. The lower the indices dipped over the opening hours, the steeper the slide became. By afternoon the slide had turned into an extraordinary plunge, with the Dow Jones industrial average diving as much as 1,597 points. All charts looked like a straight line down. It was reminiscent of the unprecedented swings of the great financial crisis in 2008.
The nightmarish flashback to the previous economic meltdown may be warranted, especially when it comes to investors using their portfolios as collateral to buy more stocks and bonds on borrowed money. These investors want to stay in the game and participate in rising markets. It’s the Wall Street version of FOMO — and it’s powerful.
The portion of the purchase price that investors borrow is called the margin debt. And in December 2017, margin debts in U.S. securities markets stood at more than $642 billion — 3.25 percent of the gross domestic product. In total dollars and as a percentage of the GDP, margin debt has never been higher. So what, you say?
Highly leveraged markets have a history of peaking right before financial collapses, which is what happened in 2000 and 2007. Current margin debt levels are more than 50 percent higher than 2007’s peak.
While a record level of margin debt alone is not a trigger for negative returns — nearly a quarter of all monthly readings since 1959 have been “all-time highs” — leverage of this unprecedented magnitude is like gasoline waiting for a match. And there’s never been more fuel for a potential one-day market implosion of 25 percent that will make February 5 look tame by comparison and lead to a broken market that’s unable to recover for years.
The sparks could range from the unexpected (a black swan event) to the merely overlooked (a gray rhino event, as in one that’s camouflaged but more visible). Here are a few swans and rhinos that could topple the market: property bubbles in Asia, Australia and elsewhere deflate; U.S. loan growth continues to decelerate; or the Federal Reserve spooks markets with a surprise interest rate hike.
Whatever the event happens to be, whenever it occurs, it creates a rush to liquidate holdings. The ensuing decline in prices eventually triggers an initial round of margin calls — the banks calling in their loans. Since margin debt is a function of the value of the underlying “collateral,” this forced selling reduces the value of the collateral further, thus triggering more margin calls. Those margin calls will trigger more selling, forcing more margin calls, and on and on it goes until the markets are down 25 to 30 percent before anybody can wrap their heads around what’s happening.
This phenomenon is not without precedent. While Feb. 5 certainly jarred markets, in terms of percentages and sheer panic, it doesn’t even place in the top 10. May 6, 2010, however, gives a better preview of just what a confluence of margin calls, unwinding leverage and algorithm-powered, high-frequency tradings can do to a market. That day saw the Dow Jones drop nearly 9 percent in less than an hour, market functions went haywire, and traders could not believe what they were witnessing was even real. Fortunately, the market bounced back that day. Next time investors may not be so lucky.
Since 2010, several investigations have been conducted, safeguards implemented and regulations enacted. At the same time, the complexity and scope of leverage are unlike anything regulators could have imagined just eight short years ago. The near-universal adoption of exchange-traded funds (ETFs) — from state pensions to global investors to Granny’s financial adviser — has changed the market ingredients dramatically. February 5 was only a hint of what could happen any day from this point forward if these never-before-seen levels of leverage are ignited. A quarter to a third of your 401(k) could be gone between your morning coffee and an early lunch, and no one would see it coming.
Jeffrey Moore II is a senior analyst at Global Risk Insights.
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