U.S. EQUITY MARGIN DEBT FLAGS MARKET TOP / THE FINANCIAL TIMES COMMENT & ANALYSIS

On Wall Street

July 31, 2015 10:10 am

US equity margin debt flags market top

Henny Sender

Where the echoes of the end of China’s bull run can be heard on Wall Street

©Tomohiro Ohsumi/Bloomberg

 

 

The Chinese stock markets have delivered a reminder — perhaps most of all to the leadership in Beijing — that markets bolstered by leverage are built on sand.

 

There were lots of reasons why the raging bull market in China came to an end but one of the principal ones was the extent of margin financing involved. Unofficial calculations overheard in the corridors of the glass towers of Hong Kong suggest that the number could exceed Rmb5.5tn, or more than twice official estimates.

But perhaps US investors similarly need reminding of this truth. Growth in margin financing is on the rise on the other side of the Pacific as well, amounting to some $505bn in June. “Margin debt has risen 11 per cent since the start of the year to reach a record high even as the rally in stocks has become increasingly narrowly based,” note analysts at research boutique Gavekal Dragonomics.

“Although high margin debt will not trigger an equity market collapse, it could exacerbate the downside move should any external shock trigger a sell-off, especially as the ratio of margin debt to total market capitalisation is approaching historical danger levels.” Moreover, “the negative wealth effect of an abrupt decline in the stock market could tip the US economy into recession”, Gavekal suggests.

It is not exactly reassuring that the last time margin debt was at comparable levels was in 2000 and 2007, according to BofA Merrill Lynch Global Research. “We see it as a yellow flag,” Merrill’s technical analyst Steve Suttmeier notes.

The probability that the yellow flag can turn red has risen after the Federal Reserve’s midweek meeting. In the words of Citigroup strategists, the central bank’s utterances imply that the beginning of the end of almost-zero interest rate policies will come “sooner rather than later”.

 

Of course, there is much more transparency in the US, and margin financing can be measured far more precisely than in China, where most of the margin lending took place in the shadow market. But even though the extent of such financing is known, there remains an element of at least potential instability in the US market as well.

Moreover, there are other sources of leverage in the stock market today that add to such concern, and these factors come at a time when the backdrop is one of deteriorating fundamentals and less liquidity — always a dangerous combination.

For example, stock buybacks have been a big contributing factor to the rise in share prices generally this cycle. Many of these buybacks have been financed with borrowed money. Share buybacks are a byproduct of the possibly perverse incentive structure arising from the Fed’s easy money policies.

 

In the short term, they are a positive for investors, but in the long term the message is: ‘We have nothing better to do with our money, certainly not to invest in our core business.’ The problem with share buybacks is that they can’t continue indefinitely. In retrospect, investors may realise that managements undertook these programmes at peak prices.

Even with the support of share buybacks, the spring quarter may be the first for the S&P 500 to see negative earnings growth since 2009, according to analysts at the Merrill Lynch arm of Bank of America.

There may also be other, less visible forms of leverage and strains on liquidity In July, investors in China tried to redeem holdings from exchange traded equity funds, expecting to receive the shares on a pro-rata basis. In some cases they could not because the firms involved didn’t have the shares in the first place, because of inadequate quotas. It is difficult – but not impossible – to imagine the same thing happening in some US ETFs.

ETFs and high-frequency trading firms are relatively young features of the US financial landscape. Many analysts fear that ETFs, with their promise of instant redemption, and high-frequency trading firms contribute to an illusion of liquidity when markets are rising that may not be there when the markets turn.

It is also not clear how much leverage both hedge funds and their investors have. One consequence of quantitative easing is that markets are more one-sided today than in the past, and that hedge funds are increasingly forced to use leverage to garner returns.

When rates do finally creep up, vulnerabilities will begin to appear as well. Count on it.