On Tuesday, we examined the use of margin in the markets… and how that’s led to lots of forced selling in recent weeks. That’s helped send the market into its downward spiral, with tech stocks taking the brunt of the pullback.
Yet when I left off in that essay, I’d just shown how drastically the use of margin has risen in recent years.
Here’s another look…
From 2009 to 2019, margin debt tripled from $200 billion to $600 billion. And we can see a near parabolic spike in margin use following the 2020 COVID crash.
So today, I want to continue our examination of the markets and determine… why has margin use grown so wild?
The answer to the question is multi-faceted, but it really boils down to one thing: “free” money.
It is important to understand that when rates are near zero and there are oodles of money in the system, not only does inflation creep up… but so too does leverage.
And ever since the housing bubble burst, we’ve been creating a perfect storm scenario…
Around 2007, the Fed funds rate was hovering around 5%. While that seems unimaginably high these days, back then, it was yawn-worthy.
Yet when the housing bubble burst, equity values spiraled lower, 401ks melted, and despair soared, the Fed knew something had to be done…
Hank Paulson left his post as Chairman of Goldman Sachs to assume the post of Secretary of Treasury. Hand in hand with then Fed Chair Ben Bernanke, he helped orchestrate the biggest bailout to date at that time.
Massive amounts of stimulus were unleashed, while interest rates cratered to zero.
And while this unprecedented move worked, it pushed us down a slide we couldn’t climb back up.
The balance sheet doubled. The national debt spiked to $12 trillion, and the money supply kept right on climbing.
And in the period that followed, the use of margin began to rise too. As I mentioned at the start, margin debt tripled from $200 billion to $600 billion over the course of 2009 to 2019.
Bailout No. 2
All seemed to be going well… until COVID happened.
Fear of a deadly virus tanked stocks – and briefly brought down the use of margin as well.
Then Fed Chair Jerome Powell and Secretary of Treasury Steven Mnuchin began orchestrating a bailout of the U.S. economy… again.
Only this one made 2008 seem like amateur hour.
Rates, which were only sitting around 1.5% at the time, cratered back to zero. And in a move unprecedented in my lifetime, the government sent out checks of free stimulus money to stimulate the economy.
And when rates dropped and the money supply spiked, leverage exploded higher. This coincided with the rise of equities. The S&P 500 tripled, while the Nasdaq rose sixfold.
Have yet another look at the chart from the beginning…
It’s easy to see a high correlation between “cheap” money, leverage, and the growth of asset prices. The value of the S&P 500 tracks quite closely with the increase of leverage in the system.
It makes sense. Money could be borrowed with effectively zero interest. And as stocks went up, the levered accounts went up even more.
That’s ultimately because brokers do their work to make money. And the spread at which they borrow from the Fed and lend to clients is what they make.
The closer rates are to zero, the tighter the spread. That means they must lend a lot to make decent money.
And, of course, when markets are trending higher and margin is being used without incident… there’s no reason to choke it off.
That’s the thing about heated economies… When things are going fine, leverage and asset prices can both grow.
Yet as I described on Tuesday… the use of leverage is a house of cards, especially at 5X or 10X levels. And any hint of a rate hike can send it toppling over…
What Happens When the Party Ends
When the Fed started talking about its plan to raise rates late last year, we swiftly saw the reaction. And this year, stocks and cryptocurrencies have plunged. The threat of rising rates has hit growth and tech stocks particularly hard.
Higher rates mean higher costs of capital. Companies that are dependent on financing their growth are punished because the higher cost of capital eats into future margins.
Yet the amount of margin in the system has exacerbated the sell-off excessively… 2,138 stocks out of the 3,760 stocks in the Nasdaq Composite Index are down 25% or more since November 15.
In other words, 57% of the Nasdaq Composite is down 25% or more.
Moreover, those stocks are down an average of 56.7% from highs.
Should fear of higher rates and inflation cause the value of more than 2,000 companies to drop by more than half?
Yet this precipitous drop can be explained by de-leveraging in the powerfully performing tech-heavy Nasdaq.
When rates rise and asset prices fall fast – and when there is a lot of leverage in the system – the unwind comes and gets ugly fast.
Someone who invested 100% of their money in tech stocks might be down 50% right now. That stinks.
But someone who invested 300% of their money in tech stocks might be wiped out completely.
And when accounts get close to going underwater, the margin calls come. Since the beginning of the year, margin debt has fallen $150 billion.
And remember, as margin calls come, selling becomes unavoidable. When it is called, selling must take place. Brokers want to protect their balance sheets; they don’t want to be left holding the bag. And as I shared Tuesday, some brokers are increasing margin requirements to 100% – effectively meaning no margin allowed.
Right now, we are witnessing an unwinding of leverage years that’s been years in the making – ever since the 2008 housing crash.
And, of course, when those margin calls come, what gets liquidated?
Certainly not your losers. You sell your winners and take some profits. And with much of the market’s gains being made in tech over the last 12 or so years, you sell tech.
That explains why growth and tech have been punished so severely this year. The tech sell-off started as a valuation repricing. But now it has tail spun into a de-leveraging.
That’s why I still believe tech and growth stocks have room to run this year. After this sell-off finishes its cycle, we could see many of these overly punished stocks return to their normal uptrend.
And that means the next few weeks could be the ideal time to build a position in this sector…
Editor, Outlier Insights
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