Wall Street Breaks Record

Jun 20, 2013 by

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Stock sellers have been working overtime to exploit recent highs by the major indices. The barely camouflaged marketing message: “You’ve missed out on one of the biggest runs in stock market history over the past four years, you poor sap. Turn over your money to Wall Street now before you look even more foolish in the eyes of your savvier and richer friends.”

As you know if you’ve followed Money Counselor even a little bit, I’m wary of stocks. I’m wary mainly because I think the risks of stock investing are at best glossed over and at worst intentionally misrepresented. For example: Anyone who pays any attention to news knows stock prices have been on a tear. But what portion of “retail investors” do you think know that the New York Stock Exchange recently set a record for margin debt, an indicator of stock market risk?

What’s Margin Debt?

I don’t want to get bogged down in technicalities here, but let’s go through a simplified example to understand the significance of margin debt.

Let’s say I decide to invest in General Electric—current price $24 per share—through my account at Brokers ‘R Us. If I have a margin account, the Federal Reserve Board says I can borrow from Brokers ‘R Us up to 50% of the initial purchase price of my GE stock. Doing so is called buying on margin. Through borrowing from Brokers ‘R Us, I can leverage my investment, potentially ratcheting my return, by buying on margin. (Doesn’t this Wall Street lingo just get you all goose pimply? I feel wealthy just using it. 😉 )

I decide to buy 1,000 shares, investing $12,000 of my own cash and borrowing $12,000 from Brokers ‘R Us at a specified margin debt interest rate. After the transaction, here’s my account equity:

Value of shares in my account: $24,000

− Account margin debt: $12,000

= Account equity: $12,000

My account has 50% equity: $12,000 equity ÷ $24,000 share value = 50%.

So far, so good (if you don’t mind being in debt).

What’s a Margin Call?

Now let’s say stocks decline generally, or GE posts poor quarterly results and its share price declines to $16 per share. The value of GE in my portfolio drops from $24,000 to $16,000. Now my account equity is $4,000:

Value of shares in my account: $16,000

− Account margin debt: $12,000

= Account equity: $4,000

My account now has 25% equity: $4,000 equity ÷ $16,000 share value = 25%.

But my Margin Agreement with Brokers ‘R Us specifies that, after the initial margin purchase, I must maintain at least 40% equity in my account. Uh-oh. I get a margin call.

I have to transfer very promptly into my Brokers ‘R Us account sufficient cash to make my account equity 40%. I need a minimum of 40% × $16,000 = $6,400 in equity, so I’d have to add at least $2,400 cash to the $4,000 of equity already in my account.

Maybe I don’t have $2,400 in cash just now. What happens if I do nothing and ignore the margin call? Brokers ‘R Us will unilaterally liquidate, at the prevailing market price, sufficient shares in my account to put me back in compliance with its 40% equity requirement.

What happens if GE shares continue to fall? I’ll get another margin call and have to add more cash to my account.

And here’s a little known ugliness: According to the U.S. Securities and Exchange Commission, under most margin agreements, even if your brokerage firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call. How ’bout dem apples?

Now Multiply By a Few Hundred Billion

Now imagine my little dilemma multiplied across millions of shareholders, which is what would happen if stocks are falling across the board. That translates to millions of margin calls affecting trillions of dollars worth of share value.

A goodly portion of margin calls will force liquidation of shares to raise cash. Forced selling at prevailing market prices exacerbates downward pressure on stock prices. Investor portfolio values may then decline further, generating round after round of margin calls as account equity keeps dropping.

How Large Is Total Margin Debt Today?

In April, New York Stock Exchange margin debt rose to an all-time record of $384 billion. However, in real dollars, margin debt hasn’t yet set a record, as the chart below shows. But it’s trending nearly straight up.

NYSE Margin Debt

Used with permission of Advisor Perspectives, Inc.

Is Margin Debt a Positive or Negative Indicator?

Would you borrow money to buy a house you expected to drop precipitously in value? Probably not. The same reasoning applies loosely to borrowing money to buy stocks. So some argue that investors’ willingness eagerness to borrow money to buy stocks indicates optimism and is an indicator of future stock price gains.

Whether you take growing margin debt as a positive indicator depends on whether you think investors’ collective sentiment is a reliable predictor of future stock prices. I believe investor sentiment is not a reliable predictor of future stock prices, but please cite studies (academic, not Wall Street) indicating otherwise if you know of any.

I view today’s high levels of margin debt as something like negative potential energy, as my college physics professors might have put it. Even the most optimistic of stock price prognosticators will concede that stock prices will fall—experience a so-called “correction”—at some point in the future. Falling stock prices will generate margin calls, and the more margin debt outstanding, the more selling pressure on stocks, and the more selling pressure, the further and faster stock prices will fall.

 The Bottom Line

Thanks to Wall Street’s one-sided salesmanship, stocks are almost certainly riskier than you think.

If you’re not financially and psychologically prepared to absorb stock market crashes (we’ve experienced two since 2000), you should not be investing in stocks, at all or to a great extent, in my opinion.

If you think you can reliably predict crashes and so get out of the market before they occur, I have a simple response: you’re wrong. (If you can reliably predict future stock prices, why are you wasting your time reading penny ante blogs instead of making money on stocks?)

And you should not buy stocks on margin unless you really, really know what you’re doing and have deep pockets.

What’s Your View on Exploding Margin Debt?

Does the trend illustrated in the graph above make you feel more or less optimistic about near-term stock values? Why?

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