Back in January I made note a few times that the last half of 2020 saw the fastest largest amount of margin debt ever accumulated in the US financial markets over six months. This chart from the St. Louis Federal Reserve shows how there is now more margin debt in the entire history of the US stock market. This week this started to become a problem showing up in the blow-up of a $30 billion dollar hedge fund.
Margin is when people use their brokerage account to borrow money to buy stocks. Odds are you have an account that lets you do that. In 2008 it became apparent to everyone that giant leverage can create financial turmoil when the stock market crashed that Fall and everyone talked about the 30 to 1 leverage that banks and lending institutions put on to create mortgages, of which ten percent called subprime became worthless.
Now this record margin debt now in the stock market is something no one wants to talk about, but it is a risk factor. It isn’t going to create a 2008 style financial meltdown or economic crisis or 1929 style stock market crash, but it is setting up a situation in which the next time the stock market has a correction it will end in true panic, perhaps like what happened last year.
Now this situation has existed since New Years and hasn’t been a problem that one could notice until this week when a $30 billion dollar hedge fund called Archegos blew up over the past week. That resulted in mega losses for several giant banks that served it and caused selling in several big cap technology stocks that it held after this fund got a margin call thanks to declines in popular fad stocks it held.
One of its biggest positions was in Discovery.
And another one was in Bidu.
I could list more, but you get the idea. The fund was using more than simple margin to leverage itself, but was also using complicated derivatives so that it could go beyond simple 2:1 margin.
The thing about these charts is that there are dozens of giant big cap tech stocks and hundreds of others that have charts now just like BIDU. While the charts for the DOW and S&P 500 still look fine, these stocks look horrible. The big decline in tech stocks was likely to cause margin calls for someone and so it did.
Margin typically doesn’t become a huge problem until the stock market averages fall more than 15%. That is a steep enough drop to cause people on margin to panic sell before they get a margin call. But a fast drop beyond that can cause cascading out of control selling. I saw that in 2008, where you could see massive margin call selling on multiple market closes. It didn’t really happen last March.
But this record margin debt now in the stock market makes it so one day it could happen again.
At the same time yields continue to go up. We’re seeing money flow out of big cap tech stocks periodically now and then and jump into cyclical stocks and “reopening plays.” That’s creating a great rotation that’s keeping the DOW and S&P 500 looking good.
But no one knows if that is the start of a new mega trend or simply a desperate topping phase created by money managers who must ALWAYS be invested in something so are jumping out of one thing and into another simply because they have to, so they are chasing strength. If that is what is the main driver of the current market gyrations, than it’s a process that won’t last forever. Something similar happened in the summer of 2000.
Either way, the market is setup to at best go sideways for the next few months. It’s time to pair down risks. That means getting off margin if you are on it. Maybe raising some cash if you are not. And this is a tough market for investors, because bonds no longer act as a safe haven. As for going long, it is only in super selective stocks and plays that it is working.
The massive stock market rally that began last April has been fun and it’s good that it brought so many new traders into the market for the first time via apps such as Robinhood, but as the year came to end the massive risks many took on borrowed money is now a black cloud that is now visible coming over the horizon.
I’m not saying be scared, I’m saying just be careful.
-Mike
