The Truth about This “Meltdown” Indicator

Keith Fitz-Gerald Jan 16, 2015
24 

We talk about why you should always be in the stock market (and NOT for the same reasons Wall Street wants you in, either). That’s because being in the markets allows you tap into the inevitable growth that comes from capitalism and, by implication, humanity’s upside.

Lately, though, people are beginning to doubt the premise behind that Total Wealth tactic.

That’s due partly to recent trading action (which is unsettling), and partly due to the hype surrounding various indicators that are almost “guaranteed” to show a looming meltdown (which is unnerving).

Right now the scary indicator making the rounds is  record “total margin debt.” Chances are you’ve probably seen the emails, too.

… according to the New York Stock Exchange, investors have borrowed more than $457 billion against their brokerage accounts as of November 2014 – a new record. The social meme – the mantra, if you will – is that so much debt is unsustainable, and that it potentially undermines the entire market.

I get that… debt is a four-letter word after all, especially when it comes to the central bankers and Wall Street fat cats. But this is different.

In fact, I’d even go so far as to chalk this up to another case of “it isn’t what it seems.”

Here’s the truth about this “meltdown” indicator.

Putting $457 Billion of Debt into Context

Total margin debt isn’t a statistic that’s calculated out of thin air. In that sense, it’s really nothing new.

Every New York Stock Exchange Member Firm is required to report total outstanding borrowing held against client accounts on a monthly basis and has been since passage of the SEC’s rule 606 in 2005. That way, the exchanges and regulatory agencies can track potential exposure and liquidity problems by determining who is leveraged up to their eyeballs and who is not.

This is important because it is the brokers and ultimately the financial intermediaries who will have to make good on any default. You could argue that lately this risk has been shifted onto the American public and I wouldn’t disagree – but let’s save that for another time.

The thinking is that margin debt goes up because investors are becoming more aggressive and using that money to buy additional securities. That somehow it’s an irrational acceptance of risk or complacency.

In reality, though, there’s nothing unusual about margin levels that have risen to where they are today. I’d even go so far as to say that while it’s imprudent, it’s not illogical. When money costs nothing, people are going to borrow as much as they can. And you can thank the Fed for that little gem, via its zero-interest rate policies.

I know the chart looks scary but, again, everything is not what it seems.

Figure 1 – Advisor Perspectives & Doug Short.com
Click to Enlarge

I say that because what these terrifying internet email chains never bother to disclose is that all that money isn’t necessarily used to buy stocks.

In fact, the money can be used any way the account holder wants – to buy a home, pay for college, an upcoming trip, or to buy more stock. As long as there is acceptable collateral posted, there are really very few restrictions.

The other thing to think about is that margin is cheaper than it’s ever been thanks to the Fed’s emphasis on cheap money. Not only that, but brokerage competition is more intense than ever before, so the terms are more attractive to clients who want to borrow than they’ve been at any other time in history.

And, finally, the S&P 500 is up 187% from March 2009 lows. Seeing a corresponding rise in margin at the same time is absolutely consistent with the Fed’s policies. That’s because the Fed has done the impossible and inflated everything – collateral and debt alike.

So the next time you see one of those panic-inducing emails and your breathing starts to quicken, take a look at the following chart of total NYSE margin as a percent of total market capitalization.

Source: GaveKal Capital

What it’s telling you is that total margin debt is less than 3% of total market capitalization. That’s practically a rounding error. What’s more, it shows you that the debt adjusted returns we’ve seen over the past few years are par for the course.

To be fair, I’ll leave it to you to decide if this is sustaining or sustainable. Charts or not, I could make the argument either way.

And that brings me to my favorite part of each column – what to do with your money.

The Key Takeaway from the Margin Debt Debate

Rising margin debt is clearly not a data point you want to watch in isolation, nor is it something you want to ignore. But keep things in perspective.

Growing up in a household where you don’t buy something unless you can pay for it, debt is not my preferred way of doing things. I don’t like it and never have. But that’s just me.

If anything gives me pause about the level of margin debt, it’s the fact that millions of Americans don’t share that attitude. Not surprisingly, I view the rising margin debt as implicit social acceptance that “somebody else” will bail the system out again if it collapses.

That means risk management is vitally important, beginning with your trailing stops. Just because everybody else is apparently throwing risk to the wind and willing to go into hock for the privilege of doing so doesn’t mean you need to.

It’s also proof positive of something else that we talk about a lot – namely that the big money is going to be made ahead by those companies answering needs humanity can’t do without and that debt cannot disrupt at any level. (That’s a big part of what makes a trend “unstoppable.”)

Not only are they more stable, but such companies tend to recover faster if there is a major correction, no matter what the cause.

For example, both American Water Works Company Inc. (NYSE:AWK) and Becton, Dickinson and Co. (NYSE:BDX) saw losses in 2008-2009 that were minor compared to those suffered by the major indices.

AWK taps into the Demographics and Scarcity/Allocation trends, while BDX also hits two of our trillion-dollar trends at once: Medicine and Demographics.

Until next time,

Keith Fitz-Gerald

24 Responses to The Truth about This “Meltdown” Indicator

  1. Tim Bailey says:

    Excellent article. The scare tactics to increase volatility seem to grow and grow.

    • Keith says:

      Thanks Tim.

      You raise a very important point and, sadly, it’s one that never dawns on most investors much to their detriment. Wall Street’s job is to make money and if that means they have to create hype to do it, than that’s valid part of their trading strategy.

      Our job – and one of the reasons I created Total Wealth – is to understand their role and to utilize every tactic at our disposal to beat them at their own game. That includes knowing when they are acting in their own interests and what tools the “publicize” to do so.

      Best regards and thanks for being part of the Family, Keith 🙂

  2. Mandy says:

    Good Morning from California! You always give me hope…Thank you for all the explanations that help me when I hear we are going down the bottom of the sea.

    • Keith says:

      Thanks for the kind words Mandy.

      While it’s easy to focus on the negative, it’s far more profitable to focus on positive – even if you have to look hard to do it and turn over a few rocks in the process!

      Best regards and thanks for being part of the Family, Keith 🙂

  3. H. Craig Bradley says:

    IGNORE THE BUZZ, (STATIC) NOISE, AND ALL THE CLAPTRAP

    I say ignore everything going on in the U.S. markets today and look ahead five years and try to position yourself most advantageously. Take my word for it, it will be a completely different world from today in many respects, some good, some not so good. The U.S. dollar will go back to trend – down and be the weak man of the world again. Other currencies besides the Swiss Franc will unpeg (from the Dollar) and appreciate.

    So, it matters very little who the next president turns out to be. Still, it will dominate the news for 2016. In just five more years, you will just look at our (worse) debt situation and lower currency exchange rate (DAX) and find us along with the PIGS of Europe. But for now, we are the strongest relative currency and economy.

    You could buy a beaten-down Russian stock GAZPROM (OGZPY) in a beaten down sector ( Oil and Gas ) and then wait for things to normalize. For Gazprom, its normally around a $15.0 stock on sale for $ 4.64 and while you wait, it pays .40/share or 8.6% yield at these prices. It is unlikely to be cut, unlike a number of U.S. Blue Chip dividend payers in energy and telecommunications.

    Gazprom’s payout ratio is only 12% vs. 45% for Johnson and Johnson ( jnj). Johnson and Johnson’s dividend yield is only 2.6%/year. See the potential (overseas)? Plunk down $100,000 in Gazprom and be paid $ 8600/year X 5 years or $ 43,000 !!. See your initial investment turn into $300,000 !!!! Try to beat that in the U.S. in the best of times ( today). Oil will be back up to $75/barrel in five years and today’s events, faces, and most people forgotten.

    Only problem (not a small one either) is State and Federal Taxes will take-away $60,000 of your future gains and leave you with only $140,000 in extra cash. Inflation (2%) further reduces the future value of this cash to about $126,000 in today’s dollars. Still, no matter what they may say, Cash is NOT Trash.

    The motivation to look ahead or over on the “other side of the pond” and take some risks and invest ( or do anything) is diminished because of the total tax levels we currently have. Taxes are a disincentive to invest, work, or do much of anything. No wonder our growth rate is less than 2% every year ( 2008-2015). Can anybody figure it out on their own?

    • Jeff P. in Canada says:

      Gazprom is not where I would consider puting my money. The sanctions against Russia are hurting Gasprom and although the Russian government is helping them out with loans, the Russian government is also forcing Gazprom to cash in their foreign reserves, that is, exchange dollars for rubles, in order to help support the falling ruble. It is only a matter of time until the sanctions hurt Gazprom in a big way and you will not be getting your dividend.

    • Keith says:

      Hello Craig.

      Wow…definitely some great thinking going on here. Thanks for sharing your perspective and your analysis.

      And, of course, for being part of the Family, Keith 🙂

    • Sandra says:

      Hello it my first time out here nice to read and learn a few things . I do have a question what stock could a person being on a fix income get into with out having trouble ? and who do they contact to invest into that stock.? thank you , Sandra

  4. raycauser says:

    Since we import about 4M crude bpd, why would anyone want to start to export US crude??

    • Keith says:

      Interesting question Ray!

      I’ve heard lots of discussion about that given the supply glut and Saudi positioning at the moment. Frankly, I can see both sides of the story. As usual, it will come down to economic incentives. Frankly, given our government’s long distinguished history with the school of unintended consequences, I don’t doubt the emergence of a subsidy program down the line to do just that…even though imports stay.

      Best regards and thanks for being part of the Family, Keith 🙂

  5. Ron nelson says:

    Thank you for the insight.
    Ron.

  6. Ted Stone says:

    Would like an update on fish. Thanks.

    • Keith says:

      You bet Ted.

      I’ll be looking into it and reporting in an upcoming column.

      Best regards and thanks for being part of the Family, Keith 🙂

  7. H. Craig Bradley says:

    IVAN THE TERRIBLE

    Jeff P:

    What you say is true, but does not yet show-up in the financial statements ( 2014). However, regarding the power of “sanctions”: Vladimir Putin is willing to let Russia take the hit (or bite) of sanctions rather than back-down. Putin publicly said last year he thinks sanctions and the West’s criticism will disappear in maybe two years time, then be largely forgotten (History). In the meantime, he can weather the adverse currency and oil markets just fine. So, Putin took a gamble, as did Europe. Let’s see who the “last man standing” is in Europe and U.S. in 2017. Any guess?

    Gazprom subsidizes most of its domestic oil and gas sales such that 25% of their profit comes from inside Russia ( where 75% of domestic sales occur). However, 75% of their profit comes from gas sales to Europe and increasingly, China. Only 25% of their sales come from outside Russia. Gazprom’s Foreign earnings matter a lot.

    The Saudi’s existing full-production quota is really hurting Russia and Putin much more than our (Europe’s) “terrible” Sanctions. Iran outlasted President Bush’s sanctions and kept up the enrichment programs ( Nuclear Weapon Research ). Iran is potentially an even bigger global influence later on.

    So, My guess if the Saudi’s don’t recant this year, there will be a huge motivation for a large, multinational Middle East Shooting War. Economic warfare usually precedes military conflicts so be prepared. Nothing more dangerous than a cornered Grizzly Bear. Be Forewarned. Oil, currency exchange rates, interest rates, and gold ( already going back up) could unexpectedly reverse at any time.

  8. Andy says:

    When you make a recommendation, would it be possible to relate M M P values regarding whether that recommendation is base builder, growth and income or rocket rider?

    Thanks

  9. Robert in Vancouver says:

    One more data point to consider is that a substantial amount of margin debt was used to buy stocks/ETF’s that pay dividends at higher rates than the margin interest rate.

    So for most of those people (including me) we are making money off of other people’s money.

    And every month or quarter the dividend payments reduce the outstanding margin debt. This builds equity that will offset a future rise in margin interest rates.

    The only real risk here is that my dividends get cut to less than my margin interest payment, or margin rates go up very sharply and quickly – like a rise of 3% in 2 months. That risk is mitigated by owning reliable dividend payers that are diversified across sectors and geographies, and ensuring my incoming dividends are at least 3 times the amount of margin interest payments.

    • Keith says:

      Hi Robert.

      Great observation and one that I totally forgot to put in the article. Thanks for the upgrade!

      Best regards and thanks for being part of the Family, Keith 🙂

  10. G Mann says:

    China uncouple its currency from the dollar
    sorta like the franc – how many went broke on margin ?
    Russia raises its oil/gas price to Europe
    how much and long to switch over to other suppliers ?

    black swan effects can happen to these borrowers
    and the tax payers can & will vote out those who try to save them ..

  11. Kevin Beck says:

    Another related story I see plenty of lately is the relation of market value (as measured by the Wilshire 5000) compared to GDP. Is there a real correlation here also? And if so, how does the effect of company buy-outs affect this, since those companies are no longer represented in the index, but they still contribute to GDP? Also the $ amount of buy-outs related to the $ amount of IPOs? Do these have any correlation to market tops/bottoms?

  12. wade says:

    Our money like the rest of the world’s money is BACKED BY NOTHING! sooner or later we ( like other nations) will
    burn out and that will be that. massive job lose and a depression that will last 10 years or better! There is only two
    ways for the world to correct economies this massive and interconnected.. One is WAR, WORLD WAR, the other
    is DEPRESSION and massive PAIN for all but the very rich! I laugh at those who think the well will NEVER run dry.

    I have some gold and silver, chickens and a garden, but will I be able to remain in my (unpaid for) home? will
    government checks dry up? we are heading at a very fast pace to UNEXPLORED WORLDS!

  13. Karl says:

    I think oil prices may be down for longer than most people expect. Inventory continues to grow in the US and reaching our storage capacity limit. Production rates will eventually drop off here, but existing frack wells will easily produce for another 2 years. The Saudis may cut back as well, but as China slows and Europe sputters, that won’t make much of a difference. Besides, in 2017 the gas to gasoline factory in LA will come on line and produce enough gasoline for 24% of US demand, cutting US oil demand accordingly. As the US ramps up LNG exports over the next few years, Europe will be buying even less gas from Russia. Russia will have to cut prices to Europe and/or build a pipeline to China. China is buying oil from Iran in exchange for installing refineries there. I don’t think Gazprom’s prospects look very good for some time to come.

  14. Will S. says:

    Whilst this isn’t a comment about the state of the U.S. economy, unless you know where that debt is being spent, you are really just peeing into the wind. (to use a well worn phrase)

    That debt may be used for investing in someone’s business to buy a new vehicle, or some new counter tops for their store, or a new computer to make their business work smoother. Or it could be being used to spend on summer getaways.

    One adds to the future health of the nation, the other to the individual’s enjoyment index.

    Companies with future growth potential, the financial resources to manage them, and the key people to make that happen in a timely manner will be useful places for some of that money.

    One micro-cap oil producer I have a small stake in is LGO Energy, with properties in Spain, and Trinidad & Tobago.
    Listed on the UK AIM index. with a recent well drilling campaign in T&T, one well came in at 6,000 bopd, but was throttled back to 1,000 due to higher than expected flows, and insufficient capacity to store it and deliver it to market. with several other wells coming in at 1,000+ and 30 more wells to drill, new properties acquired, new businesses to acquire, funding in place from a major Institutional Investor, and some hedging for the next six months of oil price fluctuation, limiting downside risk, this tiddler is expected to grow several fold in the coming 5years. I wouldn’t be in it, if I didn’t think it was at least a ten-bagger.

    LGO also has a glut of information flows set to emerge in the near-term: a new CPR report, a first fly-past of the T&T area with aerial magnetism survey carried out, and the results of that, plus info from the drilling campaign.

    If your readers have spare capital for a speculative play, this one has one of the best risk-reward profiles of any company I am invested in.

    Will. S.

  15. Mark says:

    Keith, since we all use broker accounts, how do we gauge which brokerage firms would be most likely to default in the case of a major meltdown say in the derivatives markets? I buy and sell options and I’m always concerned about those that use leverage like selling naked puts for example, and the exposure the brokerage firm inherits in this type of transaction.
    -Mark

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