Margin Debt Reaches New All-Time High - Bullish Or Bearish?

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Includes: DIA, QQQ, SPY
by: Daniel R Moore
Summary

NYSE margin debt grew to $507B in April 2015, up $30.7B or 6.4% compared to the previous month, a major brief period change propelling margin debt to new all-time highs.

On a relative basis, margin debt has reached a warning zone relative to the size of the U.S. economy.

Comprehensive reviews of a broad cross-section of debt markets including mortgage, consumer and business show similar high leverage relative to U.S. economic performance.

Debt servicing delinquency statistics show relative green flags, but a warning reversal indicator has been triggered in the business loan market.

The spike upward in margin debt appears to reflect a bullish stock, bearish government bond market play that I expect to continue until the business debt market clearly diverges.

Money used to margin stocks on the NYSE grew to $507B in April 2015 (see NYSEData.com Factbook: Securities margin debt). Looked at in isolation, you might interpret the continued inflow of leverage to buy market assets as a bullish indicator. Investors are confident in the future, therefore why not take cheap money and buy assets that seemingly just continue to rise.

The temptation to rationalize that margin activity as a positive indicator for stocks is a function of how highly correlated the level of margin debt and the major stock indexes (NYSEARCA:SPY) and (NYSEARCA:DIA) have been over the past 50 years. As shown in the graph below, the correlation factor between the NYSE margin debt and the level of the S&P 500 is .97, almost a 1 for 1 correlation through time.

Correlation does not imply causation, but if interpreted relative to the situation, the riskiness of the amount of leverage being taken on by the market can be an important indicator. For example, in both 2000 and 2007, the NYSE also set new all-time margin debt levels as the stock market set new all-time record highs for that point in time. History shows that these were unsustainable high water marks for the stock market, and the ensuing break-down in stock valuations lead to a death spiral exacerbated by margin calls.

As market leverage continues to move to new highs, will the market continue to grind higher or are we about to experience another breaking point?

Margin Debt In Relative Warning Zone

A good way to assess the risk faced by investors as margin debt increases is to review the magnitude of leverage debt relative to an economic measurement like the U.S. GDP. The country's GDP is a broad measure of economic activity, and it is reasonable to expect that debt levels should remain somewhat proportional to the size of the economy. In the graph below, you can see that NYSE margin debt relative to U.S. GDP since 1998 has typically been in the 1.50% to 2.00% range.

However, in the time periods leading up to the post dot.com crash and the 2008 financial crisis, margin debt grew much faster than the pace of economic activity, and eventually adjusted after a contraction of both stock values and the level of margin debt outstanding.

Take a look at the current situation in 2015. Dating back to the start of QE3 at the beginning of 2013, margin debt activity has been at historically elevated levels well above 2.00%. More recently, the margin activity relative to economic performance has only gotten more disproportional. The April 2015 reading of 2.89% margin debt to GDP is an all-time high. The historical data gives investors good reason to be cautious; however, being at this level does not mean an immediate break down. The ratio has been at an elevated level for the past year. The risk posed by high margin debt is in the severity of the unwinding of the market when it finally happens. The triggering event for a major stock market downturn is not likely to be directly due to margin debt, unless regulators suddenly crack down and put new rules in place. More likely the trigger will come from investor fear and reaction to disruptions in other parts of the financial system. In order to assess this risk, expanding the relative analysis to broader cross-sections of the debt market is instructive.

Business And Consumer Lending Growth Follows Margin Debt

Margin loans are not the only lending activity which is currently on a relative basis at a very high level. In the graph below, consumer credit, including securitized assets (see data) and commercial and industrial loans by all U.S. commercial banks (see data) are shown relative to U.S. GDP over the past 17 years. The year 2000 and 2007 are highlighted because these are the years in which the past two major market downturns began.

Currently both the business loan ($1.85T) and consumer credit ($3.36T) segments are at all-time highs both in absolute dollar terms and relative to U.S. GDP. Growth in each segment has been robust over the past several years, and is most similar to the time period leading up to the year 2000. Over the past year, business loan growth was a healthy 11.54%, and since the point in time QE3 was launched at the beginning of 2013, growth has exceeded 10%. Consumer credit expanded at a rate of 7.07% per annum for the 12 months prior to April 2015.

Relative to GDP, consumer credit is now 19.04% to GDP and commercial and industrial loans are at 10.57% to GDP. All measures are all-time relative highs to U.S. GDP.

Mortgage Market Recovering, But Still On Shaky Fundamentals

The data on business and consumer lending show the current market shares more similarities with the year 2000 than the year 2007 time period. Much of this may have to do with the fiscal and monetary policies being implemented during the two time periods. Overall, however, the current time period remains unique from a debt market perspective on many measures. One that I will point to is the mortgage market. The mortgage market remains in a state of slow recovery, continuing to work off a historically high degree of delinquencies.

Total U.S. home mortgage debt outstanding as of March 2015 of $13.4T (see Fed data) only recently turned the corner and began to rise again after peaking at over $15T in 2008. Mortgage debt (MBO) relative to GDP of 76% is trending downward to a point more in-line with its historical average of 60% from 1980 through the year 2000, but is not completely back to par. Single family mortgage delinquencies have been on a steady decline since the beginning of 2013, auspiciously in line with the launch of QE3. Delinquent loans declined to 6.14% of outstanding balances in March 2015, but were still well above the pre-financial crisis' monthly average of 2.24% from 1990 to 2007.

The good news in the data is that the mortgage market is not as big a headwind for economic growth as it was from 2009 through 2012. Growth in mortgage debt is a big factor in driving U.S. GDP growth. The growth was only 1.0% in 2014, but at least it was no longer negative. The expectation for the low growth rate to continue is a good reason forecasts for U.S. GDP growth remain stagnant.

Debt Servicing Trend Says Coast Is Clear, For Now

High relative levels of debt outstanding, whether business, consumer, mortgage or margin debt, are not an issue for the U.S. economy (and indirectly the U.S. stock market), as long as the debt is serviceable and loan-to-value ratio in the case of margin loans remain above regulatory thresholds and margin calls do not materialize. In order to evaluate if the current financial market is facing increasing threats due to risky debt underwriting, loan delinquency data provides useful information. In the graph below, delinquency rates in the mortgage, consumer and business loan markets are illustrated dating back to 1998.

Since 2010, the delinquency rates on loans outstanding in all 3 markets have exhibited major declines. In fact, the consumer and business loan segments show delinquency rates that are at all-time lows dating back to 1986.

But the issue with delinquency data is that it is the inflection point when the trend reverses that markets begin to become unsettled. Note the accelerating upward move in business loan delinquencies which coincided with the stock market peak in August 2000. And likewise, note the very clear upswing in mortgage and consumer loan delinquencies leading up to the September 2007 stock market peak.

As I stated previously in this article, this business cycle has much in common with the business cycle that led up to the year 2000 market peak as the fiscal and monetary policies are very similar. And the primary lending market that signaled trouble in the year 2000 tech driven business cycle was the business loan market. One could read the chart above and make the determination that the coast is clear for stocks. For the most part, I agree in the short term. But the most recent quarter of data showed the first up-tick in business loan delinquencies since late 2009.

I expect the delinquencies to accelerate in the coming year based on two factors. One, a large part of the recent acceleration in business loan activity found its way into the shale oil sector. There is a big "bust" still brewing in this market, and marginal exploration players and oil service firms will default if the price of oil stays in the $60 range as the current futures curve shows it probably will for the intermediate future.

Second, the business loan market data has a leveraged loan sector that I track on an on-going basis which is exhibiting investor expectations that there are more serious problems upcoming than is currently showing up in the delinquency data. I extend the analysis to this sector because banks have tended to avoid taking on risky business loans, particularly since Dodd-Frank regs were instituted, preferring to take only senior credit tranches in BDC capital structures leaving BDC common unit holders to absorb the risk. Take a look at the trading pattern of 3 leveraged loan BDCs (FSC) (NASDAQ:PSEC) (NASDAQ:PNNT) over the past year.

Starting in September of 2014, the share price of these companies went into a precipitous decline pattern. Coincidentally, September 2014 is the same time that Saudi Arabia dropped a bombshell on the oil market that it would protect market share by letting the price drop to clear excess production by marginal (i.e. U.S. shale oil) producers. The share prices of each of these companies have declined 25% to 35%. Recently, PennantPark shares have rebounded slightly due to an announced buyback program. Fifth Street Finance is by far the worst performer.

Sifting through the BDC financials, the smoking gun showed up in the 2014 year end and 1st quarter results. The operating results have begun to show loan valuation write-downs and net income performances reflecting losses or marginal break-even. Additionally, the FSC report showed a major portfolio company put into non-performing status. These results should not come as a surprise, but clearly the market up until September of 2014 was pricing in a perpetual state of zero loan losses. In middle market lending, such nirvana does not exist. And now that the Fed has moved to a tighter position, liquidity available to roll the loans over and kick the can down the road to obscure the non-performers is going to get harder for lending companies.

Yield Curve Divergence Likely To Signal Stock Market Breakdown

Margin debt is currently chasing stocks to new all-time market highs. Meanwhile, other elements of the financial market are beginning to show signs of divergence. Margin debt will break down when the brokers are forced to call in the loans. That will happen when the stock market breaks.

Presently, the stock market trend is upward, in defiance of trouble, which is only beginning to be recorded in the U.S. business sector. Evidence, however, is not strong enough, yet, to force any weak hands out of the market. On the contrary, the trade right now, as I pointed out in my previous post is Treasury rates up, stocks up. The reason I suspect why this trend overrides any current concern for business growth slowdown in the U.S. is linked to the current position of Treasury rates relative to stocks. As the table below shows, the Fed (and by extension the U.S. Treasury) currently has manufactured a very steep upward sloping yield curve, which is shown in green because historically an accommodative monetary policy is good for stocks. This late in the business cycle, such a steep upward sloping curve is a rare beast. In the year 2000 and 2007, the yield curve flattening had inverted. Monetary conditions were much tighter.

Based on the current yield curve relative to stocks, the Treasury market (NASDAQ:TLT) (NYSEARCA:TLH) (NASDAQ:SHY) looks like it will be the first one to undergo an adjustment (NYSEARCA:TBF) (NYSEARCA:TBT) (NYSEARCA:TTT) (NYSEARCA:TMV) prior to any major "correction" in stocks (NASDAQ:QQQ) (NYSEARCA:VTI). When I look at the yield curve, the investment grade business loan market (NYSEARCA:LQD) relative to Treasuries is a warning signal that I suggest investors keep an eye on. If Treasury rates move up and the BAA1/30-Year spread is tightened, then I suspect the U.S. economy will grow through the current problems, which is beginning to show up in the business loan market associated with the shale "bust" and over-extended tech markets. However, if the divergence between the BAA1 and 30-Year Treasury continues to widen as Treasury rates go up, my suspicion will be confirmed that the end game in the current margined-up stock market is simply to make room for the next logical trade once Treasury yields ripen - sell stocks hard, seek shelter in Treasuries as a safe haven to weather the storm.

Daniel Moore is the author of the book Theory of Financial Relativity: Unlocking Market Mysteries that will Make You a Better Investor. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.

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