Margin Debt Analysis
Below is a commentary that originally appeared at Treasure Chests for the benefit of subscribers on Tuesday, January 30th, 2007.
Why is gold rising? Answer: Because the Fed has no choice but to inflate or die. And according to Peter Schiff we are coming ever so close to a crisis in this regard, one that will level many portfolios of naïve investors. What's more, one should see no coincidence then in the fact John Hathaway, who manages the Tocqueville Gold Fund, thinks we are very close to a re-pricing of gold as well. Here is a clip from his recently published thoughts on the subject, as follows: "The next leg of the gold price will likely say more about the under pricing of risk than the traditional drivers of the metal such as inflation, deflation or geopolitical events. We believe that gold rising against economically sensitive commodities will signify that a general reappraisal of risk is underway." And of course we know gold is rising against the larger commodity complex from last week's commentary.
In terms of the messages provided above, I could not have written the words better myself, so I didn't even try. And as you know, I have been on this page for some time now, with my 'big picture' views most recently summarized in last week's commentary (attached above). Just to recap things for you briefly, and in borrowing a little help from Jesses for the purpose of rounding out more comprehensive big picture view that supports the hypothesis stock markets are also approaching a re-pricing point, one that is (also) commensurate with a growing appreciation of risk, we have the following:
• While it's true option writers continue to see no reason to increase premiums on market risk insurance, at the same time, there are technical signals being thrown off by the CBOE Volatility Index (VIX) suggestive the alert should take notice.
• Not only compounding this risk, but also magnifying the inappropriate pricing of market risk insurance today is the fact consumers are tapped-out, where once our asset service based economy slips into a real slowdown, it's difficult to identify the mechanisms by which officials will be able to rekindle growth once again.
• Further to this, with bonds looking like they are in trouble in spite of assurances from key trading partners help is on the way, not too mention direct monetization efforts on the part of domestic authorities, one does have to wonder just how close we are to hitting the wall regarding misplaced risk management schemes.
Regarding this last point, and to highlight just how far out of touch stock and bond market insurance schemes have gotten today, this year it's estimated trade in options designed to mange risk in the various markets of the world will increase to a colossus approaching $2 - quadrillion in notional value assuming current growth rates are maintained. Furthermore, it should be noted this figure dwarfs actual market values of the securities, making counter-party risks high. Of course the vast majority of these options contracts will never be paid on, nor were they ever designed for this purpose. No, you see options are just another form of quasi-currency, one that the banking community uses to aid in managing markets, not to mention boosting their own life styles. You may remember this extensive study performed on the subject last year.
And it goes further in terms of associated indicators not reflecting the 'true risk' in financial markets today, not the least of which are the extremely low credit spreads in the debt markets these days. Justifications for this condition is based on the observation corporate balance sheets are very healthy, with no consideration to those of individual consumers. This practice of only looking at mutually exclusive factors when it suits the immediate need will of course injure the financial system beyond repair in the end, as a great deal of credit is being issued now that will be defaulted on in the not too distant future, with these same companies chewing through their cash to service this debt as revenues fall. But for today, everything looks rosy and the world revolves on credit. So, the attitude is party on dude.
With respect to this attitude, and as you well know already, the bond market is not the only place investors choose to ignore risk at present. No, this attitude is pervasive through most financial markets today, both debt and equity alike. In terms of the equity markets, and a related subject we often comment on within our regular monitoring of factors that have a measurable impact on prices, is margin debt, where as you will remember from recent discussions, is on the rise at present. What's more, it's both important and telling to note margin debt thresholds are back at all time highs, levels not seen since the year 2000.
The question then arises concerning margin debt, 'is growth about to flame out at a double top; or, as with investors growing appetite for risk these days, carry on to new highs?' As usual in matters such as these, if one wishes a 'good answer', it usually pays to consult the charts to see what messages the empirical world holds. So, in this respect then, let's see just what we can learn from the following picture show, with a 'big picture' observation to kick things off. Here, the primary point being made is that credit makes the world go round, and nowhere is this understanding more evident than in the direct causal relationship between margin debt growth and the value of asset prices. (See Figure 1)
As you can see in the above, the statement 'debt makes the world go round' is not an exaggeration, at least not as far as the stock market is concerned. And as mentioned above, currently margin debt levels are back to the mania days seen in tech stocks at millennium's turn, with the big question now being, 'do we go higher?' To help answer this question, or perhaps better put, to provide a 'good indication' in this respect, as always it makes a great deal of common sense to look at participation rates, which in this case can be measured by Rate Of Change (ROC) indicators. And wouldn't you know it, based on this measure, it appears more upside lays ahead for both margin growth and the stock market. (See Figure 2)
And of course such a conclusion makes a great deal of sense simply from the perspective inflation alone should cause both debt and asset prices to rise, because both are directly linked to bringing new money into circulation in the end. That is to say without the direct monetization of securities markets, our current credit based system can only grow if debt continues to grow. This is going to be a growing concern if interest rates keep rising naturally, which appears to be the prognosis. But for now it appears price managers intend to press the issue by continuing to inflate with abandon, pushing asset prices higher, until we all come tumbling down when market support mechanisms turn non-supportive. Here, it should also be noted short sales on the New York Stock Exchange (NYSE) are back to record levels, and looking to go higher. This to points to higher prices in stocks as winter wears on, again where at a minimum, we are expecting prices to continue rising in manic fashion as the shorts are squeezed.
Continuing on with a more in depth look at margin trends now in an attempt to learn what to expect in a topping pattern, I can think of no better way to do this other than by studying history for comparables. So, that's exactly what we are going to do because I can assure you history does have a tendency to repeat in this regard. It's the psychology you know. People get addicted to gambling, and most margin players are gamblers, not investors, so behaviors repeat. But we will leave this discussion for another day. What's more important is it appears we are poised just ahead of a key turning point if history is a good guide. That is to say we are not there yet, but we could be as early as March, which of course is consistent with our larger view on the subject. Let me show you what I mean.
To start, we return to the decennial period between 1949 to 1959 simply to set context in that during this interval, stocks, as measured by the S&P 500 (SPX), had put in what was an impressive performance in discounting growth spurred by WWII, with the pattern being very similar to the current one in that starting the third year distinctive five wave patterns were traced out. Of course the scale of the move in the 50's took us to decade's end, but from a dynamics perspective, meaning because the move ran longer, a logical man might have assumed probabilities pointed to a downturn in the early 60's. (See Figure 3)
And of course such a thought process was correct. The only problem is it was off by about 8-years, as growth associated with all the war time spending and demographic trends was so strong that the good times just kept on rolling. Lest we forget these were the days of aggressive US wartime policy and the establishment of US dollars ($) as global hegemony. So, business was booming, credit was flowing, and investors were swept away with greed, much like today, where a larger degree top in stocks was not marked until margin debt thresholds had topped out prior, and contraction ensued. (See Figure 4)
Can we expect the same sequence to happen today? With the understanding history has a tendency to rhyme rather than repeat exactly, if you apply pure logic to answering this question, one would most likely come back with a 'yes' response, especially if armed with the understanding derived from this next observation. Here, we are referring to the observation that just like back in the 60's, which was the last Super-cycle Degree top in stocks, the top in 2000 was also marked by an explosion in margin debt as measured by ROC, with the big difference being very little lag time between a margin debt crescendo and prices was seen because the Grand Cycle is now maturing, meaning people have little savings and therefore depend on credit more. (See Figure 5)
Fast forward to today then, and it doesn't take much imagination to conjure up an image of history repeating itself again in this regard considering the manic proportions by which stocks are moving at present. And there is no logical reason to think the current mania (potentially marking a Grand Super-cycle top) will subside until a larger margin related cycle runs its course again, where based on the current technical predisposition of ROC indicators shown below, it appears both margin thresholds and prices are set for another push higher. (See Figure 6)
Source: All charts provided by The Chart Store.
Of course, such a set-up should not be surprising to anybody considering the predicament officialdom has gotten itself into, where it would not be a stretch to say they are literally captive to the need for speed in money supply growth rates. Just think about it for a minute. Western economies are almost completely serviced based now, with little regenerative capabilities. And for the decaying manufacturing base that remains, wars must also be manufactured in order to provide an expensive demand. Thusly, money too is manufactured to feed the bubble economies. Real estate, derivatives, stocks and bonds all require ever-increasing inflation to maintain buoyancy, where one slip-up at this point could cause an unstoppable deflationary chain reaction.
This is why even though much of the inflation is hidden from view these days in an attempt to protect the currency, the same moral hazard that existed when this was not the case is being breed today anyway, meaning by the same token one should not be surprised if margin thresholds shoot higher again soon. The central question past this point for interested investors is 'when is the larger sequence to be completed' naturally, because knowing this can make a very big difference in your future lifestyle in avoiding a potential catastrophe if one is heavily involved in stocks. And in this regard you know our views, where as early as March we could be looking at a significant to in stocks, potentially terminal in scale.
But, in doing further study on the subject, and extrapolating most probable scenarios borrowing from history once again, while this coming March may mark a turn into a relatively severe correction, based on the striking similarities seen at the echo bubble top in the mid 30's, the larger advance should continue afterwards. And as you can see in the attached analog charts comparing the two sequences, this strength could run well into next year if trading day comparisons prove more accurate than those involving calendar days.
What does all this add up to then, with margin debt simply being one more form of credit in the big picture? Answer: To me this paints a picture of an accelerating inflationary trend. And what does this suggest one should do with your money then? Should one be attempting to short the stock market in coming days? Answer: Not unless you are a proficient scalper, of which, very few live to talk about it. No, the correct answer is to get long precious metals in manner that is comfortable for you and ride the bucking bronco, even though more volatility may be upcoming as margin players get thrown around by price managers doing what they do best, that being screwing things up.
How's that for a 'how do you do?' first thing in the week.
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