Now Is A Terrible Time To Buy On Margin

Includes: SPY
by: Peter Larson

Buying stocks on margin is always a risky proposition. You can pick the wrong stocks and you end up with a leveraged loss, or you can overextend yourself during a downturn and receive a margin call. But for the last several years at least, you could say that there was a profitable spread. Long-term expected returns for an S&P 500 index fund (NYSEARCA:SPY), were higher than the margin interest rates being charged by most brokers.

Well, not anymore.

By my calculations, the implied market discount rate has fallen to 7.0%, lower than the margin interest rates available to all but the most wealthy account holders. Almost everyone borrowing to buy long term will see their profits eaten up by interest payments, even if they pick solid stocks and are able to hold them through any dips or crashes. And yet NYSE data is showing margin debt reaching record high levels.

Normally I try to shy away from saying anything that could be construed as direct investment advice in Seeking Alpha articles. But, if you are carrying significant margin in your account, and you are paying interest rates above 7%, PLEASE take this opportunity to pay it down.

These high margin, low yield conditions could precipitate a market crash, but even if that doesn't happen, it's just common sense.

Explaining the implied market discount rate

Every week for the past year I have performed a discounted cash flow analysis on thousands of stocks. This began as a project on my Seeking Alpha instablog, and has now grown into the DCFHub website. The implied market discount rate is a byproduct of this process that happens to be equal to the expected return for the stock market as a whole.

A discounted cash flow analysis requires two things; a projection of future cash flows and a discount rate to compute the net present value of those cash flows. The projection of future cash flows is simple: I just plug in the projected earnings per share and multiply it by the consensus analyst five year growth estimates for each stock.

The capital asset pricing model, developed by William Sharpe in 1964, relates the discount rate that should be applied to an individual security to the expected market return.

The formula is: ra = rf + βa (rm-rf)

where rf = Risk free rate

βa = Beta of the security

rm = Expected market return

I simplify this model by assuming that the risk free rate is zero. After all, isn't there always risk? The discount rate for each stock then becomes just beta times the expected return.

But how do I know what to plug in for the expected market return?

Well, since I'm working with thousands of stocks, that's pretty simple too. I simply determine the rate that produces valuations most closely matching actual trading prices across the set. I call this the implied market discount rate. And it is shrinking. Which makes sense; as stock prices go up and estimates of future earnings growth don't, you can expect less future return.

The following table shows how the implied market discount rate has shrunk as the 2013 bull market progressed.

The rate is currently at 7.0%, and I should admit that number is debatable. If I ran the most recent weekly analysis using the current 10-year treasury yield of 2.82% as the risk-free return instead of the simplified model, the market discount rate would rise to 7.2%. If I ignore CAPM altogether and just assume one fair discount rate for all stocks, that rate would be 7.5%. But as we'll soon see, none of these rates are high enough to justify the expense of margin interest for most retail buyers.

Comparing the discount rate to margin rates

The following table shows current margin interest rates from Scottrade. I'm using Scottrade as an example because they publish their rates publicly, and I believe these rates are typical.

Loan Balance Interest Rate
$0.01-$9,999.99 7.75%
$10,000.00-$24,999.99 7.50%
$25,000.00-$49,999.99 7.25%
$50,000.00-$99,999.99 6.75%
$100,000.00-$249,999.99 6.50%
$250,000.00-$499,999.99 6.25%
$500,000.00-$999,999.99 5.75%
$1,000,000.00 and above 5.25%

At first blush, this doesn't look too bad. Those borrowing less that $50,000 might expect a tiny loss if they trade on margin, but everyone else still has a little wiggle room. But remember, most margin accounts are not tax advantaged. Someone paying 15% in capital gains bracket would need to borrow at less than 5.95% to profit from a 7% gain, someone in the 20% capital gains bracket would need to borrow at less than 5.6%.

Only those borrowing more than a million dollars can expect a positive return on a margin trade. And even they'd have a negligible spread.

So, margin-buyers, do yourself and the rest of us all a favor and take some money off the table.

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.