Margin

Let’s be honest about it – it’s human nature to want more of a good thing… especially when that “good thing” seems like it is going to last forever.  But is there a case for too much of a good thing?

This dilemma plays out in the markets every day when investors use margin to increase the leverage of their portfolios. If you are new to investing you may be wondering what margin is. Deutsche Bank describes it as “a tool used by stock speculators to borrow money from brokerages to buy more stock than they could otherwise afford on their own.” So plainly speaking, if the stock rises, they end up making far more money.  If the stock crashes, the opposite materializes. We find this process concerning in markets like we have today where investor exuberance isn’t following basic fundamentals.

To that point, today (as has almost always been the case) margin levels have increased to record highs right along side of stock market. Just take a look…

As you can see in the chart above, the red shaded area reflects how much margin debt investors are taking on to speculate with. This illustrates the euphoria investors feel when the market seemingly does nothing but go up. They begin to feel invincible and act as such. They convince themselves that the market won’t change directions on them. Until it does… and then it all comes falling back to reality.

In 2000, investors believed that technology had created a new type of economy and that P/E ratios no longer mattered.  In 2006 the common wisdom said that real estate was in a new reality and that location was no longer the cornerstone to a great deed. In short, investors in both of these examples felt that they had a sure thing with little or no risk associated. So they borrowed as much money as possible to realize the maximum benefit… and they rode the wave until it came crashing down and there was no gain to be had. In fact, most of the losses were crippling and created pain and difficulties still being dealt with today.

So why this reminder about irrational exuberance when playing with margin? Because sadly, we see investors repeating some of these same mistakes all over again.

In a recent article from The Telegraph, the author puts it this way, “Today’s exuberant mood comes as margin debt hovers around $377 billion, just below its all-time high and well above the dot.com crash and Lehman crisis… Investors have rarely been more levered than today, and the spike in margin debt is a red flag and should be watched closely.”

We agree, and we are watching this spike very closely. Is it a perfect indicator of things to come? Of course not – and we believe there are opportunities even in the most volatile market environments. But ignoring these facts means taking unnecessary risks.

When it comes to investing, there’s nothing better than a leveraged bet that goes right… and there’s nothing worse than a leveraged bet that goes wrong.

Feel free to add your comments and share your opinions – we value the interaction.

Categorized in: Blog

This post was written by Conscient Capital