Macro Investing – Grey Owl Capital Management, LLC

(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.

A recent Wall Street Journal article highlights the macro-driven nature of today’s stock market. In it, long-time value investors lament the current environment where stocks appear to trade in unison based on unemployment data or European bank stress test results. If stocks are driven by macro factors instead of individual company fundamentals, stock pickers can’t get an edge. Market strategist James Bianco of Bianco Research asserts “stock picking is a dead art form.” Macro hedge-funds are opening at a rate equivalent to that of traditional stock funds and the big asset management firms are even launching macro mutual funds.

We think stock-picking is very much alive. In fact, we recently wrote a 20-page investment guide that details a bottom-up approach for today’s environment. Call us contrarian, but we couldn’t think of a better sign than this article that fundamentally-driven, bottom-up stock-picking is likely to make a comeback sooner rather than later. Didn’t the commodity bubble burst right around the time that the asset management firms were rolling out a new commodity fund or ETF every week? Moreover, didn’t “the death of equities” cover stories in the early 1980s signal the start of a 20+ year bull market for stocks?

The Wall Street Journal article presents data that shows the correlation of stocks in the S&P 500 between 2000 and 2006 was 27% – quite a bit of disparity indicating undervalued stocks could appreciate and overvalued stocks could depreciate as opposed to trading up or down in unison. The article also points out that correlation spiked to 80% during the credit crisis and again more recently during the European sovereign debt scare. As these issues petered out, correlations never dipped below 40% and today hover around the mid 60s. However, the article does not point out the length of time over which the correlations were measured – days, weeks, months?

The time period over which the correlation is measured is critical. “Time arbitrage” has proven to be a very effective investment strategy. Who cares if individual stocks are correlated over days and weeks when your investment horizon is years? Glenn Tongue (one of the Ts in T2 Partners along with Whitney Tilson) highlights this fact in a recent appearance on Yahoo! Finance. Like us, the partners at T2 believe buy-and-hold stock picking is far from dead. Mr. Tongue also makes a critical point about matching the duration of the investment strategy and the investors. This is why we work very hard to ensure our investors understand our process before they become clients.

Don’t misunderstand our view. We agree the data shows a significant increase in correlation between individual stocks (and we witness this as we watch the market and our individual names on a daily basis). We also agree that the macro backdrop driving the market will remain for some time. The over-leveraged PIIGS, US federal and local governments, and the US consumer will likely take years to adjust to sustainable levels. In addition, the massive government intervention in fiscal and monetary policy does not appear to be subsiding with Bernanke and company preparing for QE2’s maiden cruise. (We have discussed these issues at length in several of our recent quarterly letters.) The market will certainly react to macro factors over short time periods, but that doesn’t mean significantly undervalued stocks or significantly overvalued stocks won’t gravitate toward fair value over a longer period of time.

In our recently published investment guide titled How to Prosper in Volatile and Range-Bound Markets we detail the strategy we are employing to deal with the current environment. We believe a concentrated portfolio will be more likely to outperform – a few deeply discounted names that are returning capital to investors (via share repurchases or dividends) and that also have a catalyst can outperform even if the majority of the market moves in unison. In addition, the flexibility of corporations to deal with macro shocks (be they slower growth, inflation, government regulation) means equities have a better chance of outperforming government bonds, currencies, or commodities (areas macro funds are more likely to play in). Finally, we think valuation-based timing will be more important than it has been for traditional stock pickers. While Japan’s macro-driven market now trades at close to a quarter of its peak value 20 years ago the market experienced four rallies and five sell-offs of greater than 30% over that period. That type of volatility creates terrific opportunities for value investors to increase exposure as the macro shock of the day creates fear and to pare exposure as the fear fades away.

For a more detailed overview of our approach, you can download our full 20-page investment guide here: www.greyowlcapital.com

Category: Macro Investing

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