Leverage - Is Now The Time To Panic?

1.) BANKS – One of the biggest arguments against this bull market is that it’s only about a handful of technology companies. The problem is that the banks don’t seem to agree. Neither do industrial stocks or many of the mid-cap or small-cap companies. So far, participation continues to expand and has for some time now. I think that’s one of the biggest stories in this market. Bank stocks hitting new highs have not typically been consistent with a market top.

2.) LEVERAGE – It’s often said that leverage can kill an investor. For the most part, there’s truth in that. But if you think the stock market is about to crash because investors have borrowed too much money, you better have another reason. Too much leverage isn’t it. That might sound surprising because every few months another scary chart starts making the rounds. The chart usually comes with some version of, “The last time this happened was right before the Tech Bubble,” or, “This only happened before the Financial Crisis.” Great for clicks. But many of these charts compare things that have very little to do with one another. One of the most popular examples is margin debt divided by GDP. It sounds sophisticated and looks important too (1st set of charts below)! But if you stop and think about it for a minute, it doesn’t make much sense. GDP measures all the goods and services produced by the U.S. economy. Margin debt is simply money investors borrow from their brokerage firm to buy more stocks than they could afford with their own cash. That’s why investors pay attention to margin debt in the first place. If too many people borrow too much money, a market decline can snowball as investors are forced to sell. The problem isn’t looking at margin debt. The problem is comparing it to the wrong thing. If your goal is to understand whether investors are taking on too much leverage, why compare it to the economy instead of the thing the money is actually buying? Imagine your neighbor tells you your house is way too expensive because it’s worth more than all the corn grown in Iowa. Silly…right?! If you wanted to know whether your house was expensive, you’d compare it to other houses nearby. Same idea here. If investors borrow money to buy stocks, compare that borrowing to the value of the stock market. That’s the asset the debt is financing. When you do that, today’s margin debt doesn’t look anything like the scary headlines suggest. It doesn’t look historically extreme (2nd chart - Exhibit 3). As you can see in the bottom chart of this section, margin debt as a percent of US market cap was much higher during the 1980s and in 2007-08. That measurement is currently nowhere near an all-time high.

3.) OIL – Back on July 8, I commented that “Oil up toward $85/barrel would not be a massive surprise…”. Overnight, WTI (West Texas Intermediate crude) hit $85.45/barrel, where it met with some resistance. Now it has pulled back some to about $82. A drop toward $76 would not be surprising, given that is the low end of the trade range calculated by the rate of change of price, volume, and volatility. But since that July 8 post, that range is now trending higher again, meaning that if we tap the high $70s, it could easily reverse and head toward the trend range of $87 - $94. That will be the real test for oil. A lot can happen between now and then, but the signals suggest oil wants to move higher after a brief consolidation and/or pullback. That would have the potentially positive effect of “reflation,” which, if growth accelerates again, would likely be received positively by risk assets. A lot of things need time to develop and, of course, can change quickly.