James Saft,
Reuters Columnist
Alan Greenspan says stocks are heading higher. Margin debt is at an all-time nominal high with investors borrowing another 5% against their brokerage accounts last month alone.
Do the math.
In this case one discredited former Fed chief plus legions of leveraged investors might just equal a coming correction.
First, there is Greenspan, who has come back with a new book telling us that it didn’t happen, wasn’t his fault and anyway he predicted it all at the time.
His crystal ball, unsurprisingly, says “buy”, a sell sign if ever there was one.
“In a sense, we are actually at relatively low stock prices,” Greenspan told Bloomberg Television on Wednesday. “Indeed I say that so-called equity premiums are still at a very high level, and that means that the momentum of the market is still ultimately up.”
That use of “in a sense” is classic Greenspan, and may well form the basis for his 2016 tome explaining how he predicted the financial fallout of 2014. Further, if the “equity premium” of which he speaks is the equity risk premium, then it is whatever anyone says it is, because equity risk premiums can only be calculated by making an assumption about what future stock market returns will be. Greenspan has told us, in effect, that the basis of his optimism is his optimism. Thanks, maestro.
A cooling tonic to Greenspan’s blather is Albert Edwards, the famously bearish Societe Generale strategist, who points out that stocks are expensive relative to a measure he didn’t make up, in this case stock prices compared to company sales. The US median price/sales ratio is now at an all-time high, higher than 2006 and 2000.
“We now see many investors who had previously displayed caution and fortitude in the run-up to both the 2001 and 2008 crashes once again withdrawing from the equity markets because they simply cannot find anything cheap to buy,” Edwards writes in a note to clients.
To be sure, the straight price/sales ratio was higher in 1999 because of the effect of all those revenue-free Internet companies, but the point remains the same: the stock market is pricing companies aggressively.
MR margin on line 3
The rise of margin debt is also a fairly bearish indicator. Margin debt, money borrowed by investors against the value of their securities portfolios, exceeded US$400bn for the first time in September, according to data from the New York Stock Exchange.
We care about margin debt for two principal reasons. First, it measures the level of optimism in the market. If you are willing to borrow against your securities you must be fairly confident because you risk being forced to sell them, often at the worst possible time, to meet a margin call. That, of course, is the second reason we care: lots of margin debt means you can have lots of forced selling, allowing downdrafts in the market to take on a life of their own.
Even adjusted for inflation, this is a high figure. Using 1995 dollars as a base, analyst Doug Short of Advisor Perspectives, a firm which provides analysis to investors, calculates that margin debt adjust for inflation is a bit below the 2007 peak but above where it stood just before the dot-com bubble burst in 2000.
To be sure, margin debt is not a pure indicator of bullishness. It can represent the activity of hedge funds which sell short as well as go long.
In general though it is consistent with what a lot of investors believe: that volatility has been outlawed and that continued support from the Federal Reserve means the stock market has a safety net.
I have a hard time finding fault with that analysis. The Fed is not going to taper bond purchases any time soon, and the central bank does continue to see keeping markets happy as its unofficial third mandate.
That’s a strong reason to think financial assets have an upward bias, but only in the absence of some force that can overcome faith in the Fed and in the ability of stocks to remain unmoored of fundamentals.
What that might be is hard to say. The recovery, such as it is, is getting long in the tooth, making a US recession or downturn a 2014 possibility. And of course there is always political dysfunction and the possibility that the US shoots itself in the foot.
When leverage builds up and the wrong guys trot out the same old lines, it is time to be very cautious.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)