Levered To The Eyeballs

Includes: DIA, QQQ, SPY
by: Paulo Santos

I've already spoken on how the market was nearing a dip, due to sentiment, margin debt and its overbought nature. I also wrote on how the present environment is giving rise to a new type of trader which feels the only thing one needs to do is to buy an index and lever it up. This latest phenomenon is visible both in the margin debt statistics and the huge growth in ETFs when compared to the regular investment funds (which have been seeing strong outflows).

What I haven't done enough, is to reinforce the view that this market is levered up to its eyeballs. This is not about a single measure suggesting excessive leverage. It is instead about how every possible measure seems to be suggesting the same thing. For instance:

  • Margin debt is approaching historic highs. We only know where it stood in December 2012 - but it's fairly certain that it climbed further since then, and it was already at $330 billion, not so far from the 2007 historic high of $381 billion;

  • At the same time, the NAAIM sentiment index, which actually tallies the overall equity exposure of investment managers, came in at 104.25 - the highest number ever, and implying that investment managers are, on average, levered!

  • In the meantime, in Q4 last year we saw another example of leverage, with the massive call speculation in Apple (NASDAQ:AAPL), ending in a 35-40% slaughter.

Each of these by itself would be just one more data point to be considered along with every other factor influencing the market. But all of these are now taking place at the same time, indicating an incredibly levered market. That's the most significant observation here.

While one can trust the Fed to keep on buying and for this to give artificial support to market prices, the trend towards massive leverage carries with it the chance that the market will, at some point, plunge. Leverage usually ends with liquidation and not any other way. And as we go forward, the base on which this market stands is becoming even more leveraged, because regular folks are retiring and consuming part of their nest egg - some of which appears in the form of consistent fund outflows.


There are clues indicating that the market, for which SPDR S&P 500 (NYSEARCA:SPY) or the PowerShares QQQ (NASDAQ:QQQ) are proxies, is incredibly levered at this point. Even with the Fed propping things up, there is significant risk for a quick drop which would inevitably lead to substantial liquidation as is usual when such levered structures emerge. While the guiding principle is that while the Fed is printing all dips need to be bought, the increased risk brought about by this levered structure should not be underestimated.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.