Behavioral Finance – Grey Owl Capital Management, LLC

Why Margin Debt Matters

Margin debt is not a useful tool for market timing, but it does help to describe the general stability of the financial system.

(This article first appeared on Seeking Alpha on Jan 31, 2014.)

For the past few months, cautious investors, perma-bears, or reasonable skeptics (depending on your point of view) have emphasized the rise of margin debt balances to historic highs as one more sign that “all the passengers are on one side of the boat.” In a January 27 post, Zero Hedge’s “Tyler Durden” wrote, “margin debt rose by another $21 billion in December to an all time high of $445 billion, and up 29% from a year ago.” He goes on to explain how grossly understated this number is given hedge funds’ ability to borrow beyond traditional margin limits. Dr. John Hussman of the eponymous Hussman Funds wrote of surging margin debt at least as far back as April, 2013. Even the more staid Wall Street Journal has published warnings about the rise in margin debt. For example, the October 24, 2013 Morning MarketBeat was titled Risky Business of Rising Margin Debt.

Yet, in a December 20, 2013 commentary, technical analysis service Lowry Research Corporation points out that “since market tops are always a reflection of excessive risk-taking, it is reasonable to expect margin debt to be at high levels near major market tops. But, that does not mean it is an effective or accurate tool for anticipating major market tops. History shows that margin debt was at record levels for each of 19 years, from 1950 to 1969 and for each of 25 years, from 1976 to 2000.”

So, does margin debt matter? We believe the answer is yes. While it may not be a useful tool for market timing, it does help to describe the general stability of the financial system – particularly when viewing margin debt expressed as a percentage of a normalizing variable such as gross domestic product (GDP). The greater the margin debt as a percentage of the system, the less stable the system is.

Why is margin debt destabilizing? There are several reasons:

Margin debt is a loan that can be called at any time. Imagine how precarious the housing market would be if your bank could call you on Monday morning and tell you to pay off your mortgage by the middle of the week or they would start selling the windows and doors on your home.
The higher margin debt becomes as a percentage of financial assets, the smaller the selloff in financial assets needed to cause the margin clerk to make the above-described call. Traditional margin loans are governed by Regulation T. This allows investors to borrow against 50% of their capital initially. Therefore, an investor with $100 could make a $200 investment. Importantly, the investor must maintain at least a 25% capital ratio. So, if that $200 investment went down more than 33%, the margin clerk is calling. Unfortunately, this oversimplifies the issue. Institutional investors can use far more leverage and the margin call is governed by more than just Regulation T’s maintenance requirement. If a large brokerage firm gets nervous and wants to take down their loan balance, they can make a margin call. If they don’t like the type of collateral being held (maybe momentum stocks like AMZN, or NFLX, or YELP) they can make a margin call. To use the home analogy again, it would be as if your bank could require you to repay your mortgage if they were worried a hurricane was headed towards your neighborhood.
When margin debt is high enough, selling begets selling. It could work like this. a) Some broker-dealer(s) get over-extended by lending against a class of securities that proves to have much more downside volatile than they originally expected. As these assets selloff, the firm(s) begin to call in margin loans. b) The portfolio managers getting the margin call sell securities into a falling market in order to pay off their loans. c) The additional selling causes the market to go down more. d) Go back to a) until such time as the system is unlevered and securities are primarily owned without debt.

Thus, while neither absolute margin debt levels nor margin debt as a percent of GDP may be good market timing indicators, significant margin debt IS emphatically a sign that the system is unstable. We submit the following chart of the two most recent margin debt peaks as evidence.

This graph, created using Bloomberg Financial, shows the absolute dollar amount of margin debt from the end of 1999 through the end of 2013. At the margin debt trough in September 2002, the S&P 500 had fallen 45% from its August 2000 level. At the margin debt trough in February 2009 the S&P 500 had fallen 51% from its October 2007 level.

The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this blog will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

A complete list of recommendations by Grey Owl Capital Management, LLC may be obtained by contacting the adviser at 1-888-473-9695.

The Deeper the Slump, the Stronger the Recovery?

In September, (seemingly perma) bear Jim Grant announced his bullish turn in the Wall Street Journal. He summarized the core of his argument by quoting Michael T. Darda, chief economist of MKM Partners. We repeat the quote here: “The most important determinant of the strength of an economic recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.”

Mr. Grant continues by pointing out that inhospitable government action does not provide a reasonable argument against a snap-back, as the mid-30s showed four years of close to 10% annual expansion despite Roosevelt’s anti-business activities. In addition, the combination of government fiscal and monetary stimulus this go-around is 19.5% of GDP compared to the average recessionary government response that has measured just 2.9% of GDP.

Mr. Grant finds himself in good company. Close to the market trough in April 2009, Ben Inker of GMO published a piece titled “Valuing Equities in an Economic Crisis.” The crux of this piece is that it is relatively easy to value a broad index given the long-term stability of the economy. The US economy has always gotten back to its long-term growth trend following recessions, including the Great Depression. Mr. Inker points out that the 1929 25% fall in real GDP “was a fall in demand relative to potential GDP, not a fall in the economy’s productive capacity, and so the economy eventually got back onto its previous growth trend as if the Depression had never happened.”

These arguments certainly have merit. Not only do they come from some of the investment world’s preeminent thinkers, they also make logical sense. However, from an investment process standpoint they highlight a common analytic error: focusing on experience versus exposure. (This is the same analytic error that led people to believe that because country-wide housing prices had never fallen on an annual basis, they never would.)

Which leads us to ask the question, what is our exposure if we follow this line of thinking? Most importantly, these analyses focus on the US economy. (Mr. Inker does make reference to the rebound of Japan and Germany post WWII, but not much detail is provided and like the US period cited, these were 20th Century industrialized economies.) Interestingly, Samuel Brittan wrote a piece a couple of weeks ago in the Financial Times saying “Goodbye to the pre-crisis trend line” citing an IMF analysis that included a much broader swath of global recessions. Mr. Brittan points out that this analysis tells a far different story from Mr. Grant’s and Mr. Inker’s: “much of the loss of output in a severe recession is permanent and that the economy never gets back to its old trend line.”

In conclusion, while Mr. Grant and Mr. Inker may be proven correct and the US may experience an extraordinarily powerful recovery to match the recent downturn, making a binary investment decision based on that hypothesis does not take into account one’s exposure. (If looking beyond the US, it does not even appear to take into consideration experience.) With total US debt still at very high levels and anemic fixed private investment (to name just two systemic issues), betting on a strong economic recovery based solely on the depth of the slump does not appear to us to provide a necessary “margin of safety.”

Financial Advisers Exhibit Harmful Bias Too

The May/June edition of the CFA Institute’s Financial Analysts Journal features the article, “Should Good Stocks Have High Prices or High Returns?” Not withstanding the ambiguity of the term “good,” the logical answer to the question is that the fair price for any investment is the future stream of cash flows the investment will provide, discounted at a rate that incorporates the expected natural rate of interest over that time period and a risk-premium to account for the possibility that the cash flows don’t occur (or the timing changes, etc.).

The article goes on to define “good” using several metrics. One metric is the amount of leverage a firm has – low is good, high is bad. The higher the leverage, the greater the possibility the firm goes bankrupt and the future cash flows don’t occur. So, based on this definition of “good”, a “good” stock should have a higher price and a lower return. Think about it this way: A given firm’s equity should have a higher return than the same firm’s debt because (among other reasons) the debt gets paid first and therefore has a higher probability of being paid. All else being equal, a firm with lower leverage has a smaller chance of bankruptcy than a firm with higher leverage and thus a greater probability of paying the expected cash flows. Thus, the risk premium should be lower and the expected return lower for a firm with less leverage. The article highlights empirical evidence that bears this out.

Here is where it gets scary: When asked about this issue, professional financial advisers gave diametrically opposed answers depending on how the question was asked. When asked if they required a higher rate of return for a stock with higher leverage, 86.2% of advisers said yes. When asked if they expected a higher rate of return for a stock with higher leverage, only 12.5% of advisers said yes. Advisers are clearly prone to many of the same behavioral biases that affect laymen.

Two important conclusions can be drawn from the article:

Aspects of the stock market are NOT efficient. When professionals answer the same question regarding valuation with opposite answers depending on how the question is framed, mis-pricings will abound.
When seeking investment advice: caveat emptor. As the article states, “avoiding investment mistakes is one of the leading reasons for using the services of financial advisers. The value added from the advice, however, is compromised if the advisers are subject to the same biases as the individual investors.”