The stock market has been up all the way since the beginning of the year.
Despite the economic woes of the average citizen, our stock market seems to be racing all the way to the top. We’ve already addressed questions as to whether the stock market is overvalued quite a few times on this blog. But we’ve never discussed the hidden accelerator that can drive the market all the way up – or down.
We’re talking about stock market leverage.
As we all know, leverage is an amplifier. When things are good it’s great, but when things are bad it’s worse. Leverage in the stock market can be gauged by a figure known as margin debt, which is debt a brokerage customer takes on when doing margin trading. The NYSE tracks this figure monthly, and the October 2017 figure of $561 billion is the highest in history.
The growth in margin debt is also increasing even faster than the red hot American stock market. Take a look at the chart below. In previous years, growth in margin debt remained lower than S&P500 growth. But since the last recession, that trend has since reversed and margin debt is threatening to spiral out of control.
What’s even more worrying is that margin debt isn’t the only thing that’s pumping leverage into the stock market. It’s just the most measurable metric. Securities-based loans, in which loans are provided with securities as collateral aren’t tracked by the SEC or FINRA.
There is growing concern about just how much this ‘shadow margin’ is adding to the overall leverage.
Even some senior Fed people are sounding the alarm bells. Dallas Fed Chairman Robert Kaplan , in an end-November essay titled ‘A Balanced Approach to Monetary Policy’, specifically highlighted the “record-high levels” of margin debt as a major cause of concern. Kaplan writes:
“I would also note that margin debt is now at record-high levels. In the event of a sell-off, high levels of margin debt can encourage additional selling, which could, in turn, lead to a more rapid tightening of financial conditions.”
Translation: If a sell off is triggered, the insane levels of margin debt on the market could turn that sell off into a bloodletting.
Kaplan goes on to note other “excesses and imbalances” accumulating in the economy that can result in shock landings for the economy as they inevitably correct themselves. Among the excesses and imbalances that he is monitoring include:
- High stock market capitalizations compared to GDP. That value currently stands at 135% which is the highest since the turn of the century. He goes on to note that “commercial real estate cap rates and valuation measures of debt and other markets appear notably extended.”
- Unusually low volatility. The market has been up, up, and up. It’s now been a year without a 3 percent or more correction in the US market. How long can this last?
- Government debt levels and size of unfunded entitlements. The former just hit 105% of GDP growing by $723 billion in the past 12 weeks after the debt ceiling was lifted. Kaplan notes unfunded entitlement amounts totaling $49 trillion and says “In my view, the projected path of U.S. government debt to GDP is unlikely to be sustainable—and has been made to appear more manageable due to today’s historically low interest rates.”
Even Fed Chairman Yellen voiced concern, telling Congress that she was “very worried about the sustainability of the US debt trajectory.”
Could the stock market be a giant leverage driven ticking time bomb? Or will we look back at this period as a time of unprecedented corporate prosperity? Intelligent investors aren’t waiting to find out. They are hedging their bets by diversifying their portfolios into long term stores of value, namely precious metals. These are investments that have proven time and time again to be one of the best ways to hedge against the economy as a whole. And in this environment, it might be your safest bet.
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