Rick Bookstaber p a rt I n G s h o t
A Whipsaw In The Making ?
Among all the new market risks economists are focused on , there are old standbys that bear watching .
Alot has happened over the past year to change the nature of risk in the stock market . as the threat of Covid-19 wanes , economists are increasingly turning their attention to other threats , including possible inflation and the effect of climate change on the economy , not to mention the emergence of the “ meme ” stocks that suddenly shoot up in possibly unsustainable value .
But behind these risks lurk more perennial ones : Investors ’ holdings are increasingly concentrated , and they have taken on more leverage to purchase securities . When taken together , these two things represent warning signs of market vulnerability , and when they unravel , they can multiply market shocks , since those investors who are too leveraged can be forced to sell during a market downturn . When their holdings are concentrated , that selling focuses on a few markets or sectors .
In the extreme , the result can be a crisis cycle : Forced selling means prices drop further . the feedback continues and worsens as more investors , even those who aren ’ t as levered up , are pushed into the fray and unload their holdings . these dynamics accelerate when sudden and extreme market action dries up investors ’ liquidity . as more and more people sell , those on the other side of the trade — the liquidity providers — are caught off guard by the sudden drop and move to the sidelines .
If we want to understand the risk , we need to look at the market today , and leverage is at the forefront . let ’ s first consider free credit balances and margin debt — i . e ., loans to investors from brokerage firms . the loans are collateralized by securities . If the securities go south , that collateral is sold , adding downward pressure on the market . the
free credit balances are investor money that the brokerages are holding — cash swept into brokerage accounts , for example . ( these are the “ positive ” while margin loans are the “ negative .”) take these things together , and you get a holistic measure : the lower the value , the greater the leverage . as the first chart shows , free credit balances net of margin debt is at the lowest level in two decades .
Historic Free Credit Balances Net Of Margin Debt 200 100
0 -100 -200 -300 -200
‘ 98 ‘ 00 ‘ 02 ‘ 04 ‘ 06 ‘ 08 ‘ 10 ‘ 12 ‘ 14 ‘ 16 ‘ 18 ‘ 20 source : the financial industry regulatory authority
another common way to look at market leverage is to normalize it by comparing it to either market capitalization or Gdp , since rising equity prices will in their own right increase the dollar amount of a given leverage multiple . the second chart shows margin debt as a percent of Gdp . It is at the highest level in the past two decades .
It is natural for margin debt to increase during bull markets , and thus the rising market tends to be “ spring-loaded ” to accelerate a retreat . continued on page 57
60 | financial advisor magazine | July / august 2021 www . fa-mag . com