Stock market volatility surges as margin debt hits danger level

NYSE margin Aug15

Global stock markets turned in a vintage experience last week for those who like horror movies.

Continued sell-offs in China finally convinced some financial investors, and some senior Western policymakers, that its economy might not be quite as strong as they had assumed.  The ensuing panic led to record profits for the high frequency traders (HFTs), as the Dow Jones Index fell 1000 points at one very scary moment – and then recovered.

The market recovery was led by Ray Dalio, boss of the world’s largest hedge fund, Bridgewater Associates, who forecast that the US Federal Reserve would not raise rates – and would instead launch yet another round of Quantitative Easing:

We are saying that we believe that there will be a big easing before a big tightening

And almost immediately, the head of the New York Fed rushed to assure investors that, indeed, bursting the stock market bubble was the last thing on the Fed’s mind, saying that:

the argument for tightening monetary policy as early as September seems less compelling to me [now] than it was a few weeks ago”. 

This highlights how the role of stock markets has changed completely due to the Fed’s money-printing.  They used to be a place where companies would go to raise money to expand their business.  But today, companies have become the biggest buyers on Wall Street.  Goldman Sachs report that share buybacks are running at a $600bn rate – around 30% of companies’ total cash spending.

The Fed, like other central banks, has counted on creating a ‘wealth effect‘ via ever-rising stock markets to create economic recovery.   In turn, this has encouraged hedge funds like Bridgewater to borrow heavily in the belief that the Fed would never let markets fall.

But one day, all this borrowing has to be repaid.  And so Fed governors have recently tried to boost the market via speeches and press comments rather than new money-printing.  But whilst talk can stop markets falling, it can’t push them higher.  As the above chart on New York Stock Exchange margin debt shows, the S&P 500 peaked in May (blue line), once margin debt had peaked in April (red).  And as I noted back in June:

New highs for margin debt have not been good news for investors in the past.  The astonishing surge in leverage in late 1999 peaked in March 2000, the same month that the S&P 500 hit its all-time daily high…. A similar surge began in 2006, peaking in July 2007, 3 months before the market peak.

So Dalio is therefore quite right to suggest that more QE is needed if stock markets are to move higher.  But this could be a very risky move in a US Presidential election year.  Populist candidates such as Trump and Sanders might well ask what had happened to the $4tn the Fed has already spent on QE since 2009.

Volatility on last week’s scale is normally a sign that the underlying direction of the market is reversing.  The bulls are trying to take prices higher, but the bears have spotted that their firepower is reducing.  This confirms the insight I was given by one money manager back in December:

“His view was that the lower oil price would help to keep inflation low, and so delay interest rate rises till Q4 2015.  This view means he has to continue investing in the markets, even though he thinks they are all wildly over-valued.  His argument was simple, namely that the Fed and Bank of Japan and others are forcing him to invest in stocks as the money earns nothing sitting in the bank.  He is being effectively held hostage by the central banks.

“His own personal worry, having experienced the 1994 bond crash, is that whilst everyone thinks they can get out ‘before the market turns’, common sense also says everyone will try to stay in until the last possible moment, to maximise returns.  Then everyone will charge for the exits at the same moment, and there could be blood on the street.”

Today, as we enter September, its hard to argue with his forecast.  What happens next is anyone’s guess:

  • History would suggest that the most likely outcome is for a repeat of the 2000 and 2007-8 experience, where margin debt is unwound quite violently as investors rush for the exits in a panic
  • But maybe, ‘this time is different’.  Maybe the Fed will not only abandon hopes of being able to raise interest rates, but also follow Dalio’s advice and go for another multi-$tn QE stimulus package

It could be a fun-packed autumn for those who love horror movies, whilst this battle is fought out in the markets.

My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments: 
Brent crude oil, down 56%
Naphtha Europe, down 57%. “Market fundamentals are weak on signs of softening US summer gasoline demand and cuts in cracker run rates in the key export market of Asia.”
Benzene Europe, down 63%. “Prices hit their lowest point since April 2009 earlier this week amid global downward movement and the wider macroeconomic bearishness stemming from the collapse of Asian stock indices.”
PTA China, down 47%. “Market fundamentals remain weak”
HDPE US export, down 34%. “Domestic export prices continued to drop, as suppliers ran after demand in offshore markets.”
¥:$, down 19%
S&P 500 stock market index, up 2%

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