Earnings, Margin Debt, And Safety

by: William Darusmont
Summary

Earnings do matter! Not just forecast but REAL, especially for IPOs if they are negative!

Margin debt, and both the S&P 500 and the Wilshire 5000 have a near perfect correlation!

Don't just sit there, create an exit strategy! Trees don't grow to the sky!

Following monthly changes in margin debt (easily available online from the Fed and other sources) can be a valuable resource. When it is low, it is a sign of negative market sentiment. Then, as the market gains traction, margin borrowing increases with it - a good sign! But then, as the market continues to heat up, weaker and less informed players climb on board. This intermediate phase can last for extended periods of time. In the final stages, the market itself is overheated and often grossly overvalued, and that is where it can be a useful indicator of sentiment and "irrational exuberance" as Robert Schiller would say.

We are at one of those junctures with limits on how much more it can grow and how much effect it can still have on the overall market. A coincident indicator is Initial Public Offerings (IPOs), which become overhyped and surge when trading begins but quickly fade along with volume. Here are some thoughts:

  • Beware of IPOs... unless... you can get in on the offering. Surges like this never occurred until 1987! Why?
  • 1987 was the beginning of the dotcom boom. A few IPOs even doubled on the first day of trading. That brought in day traders, some who quit their jobs - most failed.
  • Prior to 1987, in order for any respectable investment banker to allow a deal was to have positive earnings in three of the last five years. Starting in 1987, all you had to have was 'an idea'.
  • The Crash of '87 (October) more or less brought an end to the high fliers. Not until the social media craze did it occur again. Note that Facebook (NASDAQ:FB), and especially Google (NASDAQ:GOOG) (NASDAQ:GOOGL) failed in their IPOs plunging almost immediately. I should have bought Google at $50 after being priced at $85 (Buffett has the same lament).
  • It was Ayn Rand acolyte, "Sir Alan of Greenspan" who caused the problem in the wake of the collapse of Long-Term Capital Mis-Management in late 1998. The Fed had been on the verge of tightening due to an overheating economy but this forced The Fed to do the opposite. Greenspan never tightened again even after LTCM market risk proved short lasting, and the housing market overheated.
  • As if this wasn't enough, after a short study allowing the five largest NASDAQ stocks to be marginable, the Fed made ALL NASDAQ stocks marginable - from the date of the IPO (note foreign stocks require 'seasoning' before being eligible to trade on U.S. exchanges). This caused margin borrowing, which had been low to soar to records, carrying the stock market with it. Also, none of the big brokers would lend against the unseasoned NASDAQ stocks or even smaller more volatile ones, but the discount firms servicing day traders did: that was, and remains, their bread and butter!
  • Y2K put a damper on the entire market but due to the advent of the euro on 1/1/99, which immediately plunged, foreign money kept pouring into U.S. markets. Finally, in the Spring of 2000, it stopped causing stocks to unravel... even IBM broke $100 around mid-year, and in October, tech stocks plunged. Goldman Sachs' (NYSE:GS) chief strategist, Abby Joseph Cohen, told everyone not to worry and hold on. Those who did were crushed.
  • The housing boom created the next wave, and when housing peaked along with the stock market (mid-2007, not 2008), investors began bailing. Borrowing took off again along with the market bottom in March 2009.

This brings us to the present where margin borrowings remain at record highs ($660B in July) and more than three times even the 2000 high. Obviously, they also contributed to the 2008 credit crisis after peaking at approximately $425B when the market topped out in 2007, plunging to $200B in 2008!!! Early in 2016, the low was about $475B and began to surge the day after the election (removal of uncertainty). It has steadily climbed at the steepest level on record to $660 billion in June! Bubblicious! Since 1986, there has been a direct correlation between margin borrowing and the broad market (S&P 500 and Wilshire 5000). These numbers are approximations for the full story, and correlations, which are troubling, see Ed Yardeni's website since the charts cannot be copied.

The three periods I have discussed stand out clearly on Yardeni's charts. I know of no better correlation to indices than margin borrowing. Of course, it isn't a predictor but if you see rapid decreases, market declines are to be expected and should be respected. Many people say they are long-term investors, so they don't care but these three boom-busts show that buy and hold is not always a good thing.

Note that all three peaks margin borrowing was higher than any previous period. Even more significantly, banks are now making loans to customers without knowing how the money will be used, and the discount brokers are allowing loans based on the value of the total portfolio, which can then be used to buy more securities, creating an effective, if not actual, margin loan. I believe these could add at least another $5-10 billion or more to margin amounts.

The significance, once again, is market euphoria, despite signs of an overheated stock market. Margin loans are always in the weakest hands, and thus vulnerable to psychological factors, especially true when you are borrowing without it being tied to a specific asset.

So, what can you do? Pay close attention to the market and have an exit strategy. Remember in a 'rout', you can't sell what you want to sell without driving the price lower, you sell what you can sell: precisely the stocks that will recover first.

Here is how margin borrowing has grown. Prior to 1980, the highest levels ran between $10-12 billion. In 1983, it surged from about $13 billion, nearly doubling to $22.79 billion. It grew steadily to $26.64 billion in 1985, $37.09 billion in 1986, and peaked at $44.17 billion in 1987 - reaching that level in September - just before the crash of October. Coincidence?

Since 1988, it rose from $31.3 billion to $36.66 billion in December of 1991! In 1992, it grew to $43.99 billion and hit $60.31 billion in August of 1993. Note that in no year between 1990 and 1993 was any monthly low below the prior year's high!

Here are the highs from 1992 to 2000 in millions, as the stock market soared:

1992 $43,990 (December)

1993 $60,310! (December)

1994 $63,070 (August)

1995 $77,875! (November)

1996 $97,400! (December)

1997 $128,160! (October)

1998 $154,370! (July)

1999 $228,530! (December)

2000 $278, 530! (March) - the peak, not to be surpassed until July 2007 ($381,240)

In 2008, borrowing plunged all year to $186,710 in December, bottoming in February 2009 at $173,300. The ensuing rally carried it back up to $231,820 in October, then:

2010 $276,558 (December)

2011 $320,706 (April)

2012 $330,556 (December)

2013 $444,931! (December)

2014 $465,720 (February)

2015 $507,153! (August)

2016 $501,125 (November)

2017 $580,945B! (November)

2018 Range: $600 billion in January to an astounding $650+ billion in July, eclipsing all other records!

Given the way the market is currently struggling to continue gaining ground, this is a screaming warning of an overheated market. Margin requirements have fallen from 100% in 1944 to 50% since 1974.

The markets are much riskier now than before due to a change on margin eligibility by the Federal Reserve in 1998, causing the largest one-year increase in margin borrowing (48%) in history. The problem began in May 1998 when the Fed made the five largest NASDAQ stocks eligible for margin borrowing. It was a test and seeing no problems at the November 1998 meeting they made ALL NASDAQ stocks marginable - from the date of listing! Think about that for a moment: that includes IPOs on the first day of trading! How could they have done this?

In mid-1999, I was at a Bond Club luncheon at the San Francisco Federal Reserve, hosted by Robert Parry, President, a former bank economist. He gave a speech and then opened it up to Q&A. I asked why the Fed hadn't increased margin requirements (Regulation T) due to the surge in borrowings. He said that "Chairman Greenspan doesn't feel it is fair to small investors since institutions can borrow elsewhere." I didn't think this was part of the job description for the Federal Reserve Chairman. I then asked, why after just a six-month trial did the Fed make all NASDAQ stocks marginable from the date of listing effective January 1, 1999. He stared blankly at me, and asked, "are you sure about that?" I began to shrink in my chair as my peers all stared at me aghast. When I got back to the office, I immediately went to our library and pulled out the November 1998 Federal Reserve Bulletin and there it was. I faxed it to him, relieved, and got this reply: "oh, that." Now I really was concerned. The market was on borrowed time. Researching this article, I ran across the following from the San Francisco Fed, which should have demanded an explanation on the prudence of the changes to marginable securities:

"Between October and December 1999, margin credit extended by NYSE member firms increased 25%, from $182 billion to $228 billion, while the stock market's value went up by 11%. In January of this year, despite the 4% drop in stock market value, margin credit continued to rise to $243 billion, a 6.5% increase from December.

The recent rise in margin credit is notable because it has outpaced the rise in stock market valuations. (Chart) plots the ratio of margin credit to total market capitalization from January 1971 to January 2000. The strong growth of margin credit in recent months has pushed this ratio to 1.58%, a record high during the past 29 years-eclipsing the previous peak of 1.53% set in October 1987 following the stock market crash. Nevertheless, this ratio is still relatively tame compared to the estimated 10% level reached at the height of the speculative fever during the late 1920s." - Source: Margin Requirements as a Policy Tool?

Note that it wasn't the major broker/dealers who were making those loans on speculative stocks, but the discount brokers… the same ones financing most of the borrowing today! This means that stocks bought on margin were now in the weakest hands. Still, the Greenspan Fed never raised interest rates, which might have at least reduced market risk.

Here is what is so troubling today: Margin borrowing stands at 1.7x the August 2007 high; 2.3x the March 2000 high; and 14.7x the September 1987 high. This as the S&P 500 sits just below the 1/28/18 record high of 2,870.

As for preparing an exit strategy, review your portfolio, noting the following on individual holdings: P/E ratio; Forward P/E ratio; PEG (P/E to growth rate), and the Beta (relationship to the S&P 500) of individual holdings and the overall portfolio. You can then see which stocks are the most vulnerable to a correction. This is not a substitute for fundamental analysis of your holdings which you should have done before purchasing them, right?

I hope you find this review of value and that it makes you think about volatility, even among the best stocks.

The author does not engage in margin borrowing, options trading, or shorting securities.

Disclosure: I/we 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.