Deutsche Bank Special Topic: Red flag! – The curious case of (NYSE) Margin Debt

A great report from DB on hidden market risks, herewith some excerpts:

"The New York Stock Exchange (NYSE) tracks margin debt for the US market. The April 2013 figure of USD384bn marked an all-time high since records started in 1959!. When netting out account credit metrics, such as Free Credit Cash and Credit Balances in margin accounts, total investor net worth just hit a record low since 2000 at USD106bn. In short, investors have rarely been more levered than today!"

"According to our observations, a m-o-m change in NYSE margin debt >10% has to be taken as a critical signal as we discover astonishing similarities in the sequence of events among all crises (the new technologies market around 1999/00, the Great Financial Crisis around 2007/08) and in 2013. As the S&P 500 just hit a new all-time high, investors might want to ask themselves when it is a good time to become more cautious – yesterday, in our view."

"Since the records started in the late 1950s, we observe margin debt tracked by the New York Stock Exchange (NYSE) rose to an all-time high in April this year."

"Most interestingly, margin debt follows the pattern of exponential growth when equity markets surpass previous record historic levels and peaks ahead of the the equity market, i.e. 1/2 month ahead during the “new technologies market” around 1999/2000 and 3 months ahead during the “Great/Global Financial Crisis” (GFC) around 2007/2008. As it is difficult to identify such an absolute peak, we find it useful to look at more sensitive measures, i.e. month-on-month changes. It seems as if a threshold >10% in the m-o-m change delivers meaningful signals when the sequence starts."

"In this way, it is most alarming to see that the first signal lit up in January this year.

Market analysts track margin-debt activity as an indication of investors’ appetite for speculative trading. But a potential pitfall for those trading on margin is a sharp decline in stock prices, which can expose investors to margin calls, requiring them to post additional collateral or having their brokers sell their securities.That’s why high levels of margin debt can be worrisome – a wave of margin calls triggered by a sharp market correction could exacerbate the selling pressure on stocks, making matters worse.

Consequently, high margin debts show the effect of over-leveraging and mispricing of risk in our financial system. Particularly worrying in this context is the fact that margin debt is just one tool available to investors seeking leverage. Options and futures make it easier to obtain leverage as well. In other words, the record margin numbers may understate the situation. And did you know? The interest on margin debt is taxdeductible in the US which adds to the incentive to lever up.

Besides, with the bond market weakening, the cost of margin debt is going up which will also trigger liquidation of this debt with an obvious impact on stock prices supported by this borrowing."

(...)

"Relative to US nominal GDP, many quotes in the financial press since the 1980s highlight the critical level of c2.25% as worrisome, a level we just crossed in January this year. In retrospect, we observe that this threshold has been useful to identify the peak in the equity market in 1999/2000 and in 2007/2008. However, it failed to deliver a meaningful signal back in 1987 (albeit marking a record high in those days). The June 2013 figure currently stands at 2.35%."

"More interestingly, the ratio of margin debt relative to total market capitalization also works as a meaningful signal when using a c2.25% threshold with the noteworthy difference that the 1987 stock market crash was detected as well. As the current level stands way above this threshold, observers should be alarmed. The June 2013 figure currently stands at 2.66%."

"...It can be debated quite controversially, whether the current level of margin debt is to be considered as excessive, but findings in this report indicate the time has come to stop debating on pricing levels among equities (being cheap relative to bonds on the one hand side, but fairly valued compared to own historic levels on the other hand side) and start debating on leverage in the system, which has undeniably reached a critical level, once again."

...

"Finally, we point to the fact that not only invesors in equities are subject to this matter but also investors in fixed income products (aside from hedge funds and macro/cross asset funds). The mindset of investors in DM government bonds (especially in US Treasuries and German Bunds) has been shaped by a 30-year long bull market, as long as entire careers for some."

...

"In summary, this does not necessarily mean the peak in equities is just around the corner. It means the underlying basis on which prices trade is most fragile and, more importantly, the higher margin debt levels rise, even a less severe sell-off in equities could trigger the sequence of events outlined in detail above."

...

"This leaves us with the hope that not all the margin calls come at once in case a sell-off in equities occurs. Gold and silver have been first in line to observe selling pressure but plenty of other assets could have to be sold down as well to meet (latent) brokerage margin calls."