Margin Debt, the Stock Market, and QE
Doug Short (whom most of you know) always complies data and interesting/useful studies at his excellent website. This study is another good one. Please read the whole thing, I will just be highlighting a small part of the post
NYSE Margin Debt and the S&P 500, By Doug Short, July 26, 2011
The next chart shows the percentage growth of the two data series from the same 1995 starting date, again based on real (inflation-adjusted) data. Margin debt grew at a rate comparable to the market from 1995 to late summer of 2000 before soaring into the stratosphere. The two synchronized in their rate of contraction in early 2001. But with recovery after the Tech Crash, margin debt gradually returned to a growth rate closer to its former self in the second half of the 1990s rather than the more restrained real growth of the S&P 500. But by September of 2006, margin again went ballistic. It finally peaked in the summer of 2007, about three months before the market.
After the market low of 2009, margin debt again went on a tear until the contraction in late spring of 2010. The summer doldrums promptly ended when Chairman Bernanke hinted of more quantitative easing in his August 27th Jackson Hole speech. The appetite for margin instantly returned.
I want you to consider this last sentence.
Like I have stated on many occasions (such as here, here, and here), Quantitative Easing is not inflationary. It is absolutely nothing more that a bigger version of OMO (Open Market Operations) that the Fed does every day to maintain control of the short term interst rate (the Fed Funds rate). OMO is nothing but a swap that trades reserves for Treasury bonds. At the end of the swap, there are no new net financial assets in the banking system for utilization (hence the term swap).
But! (you say), ever since QE2 was introduced all kinds of risk asset prices have risen dramatically! Surely this must be proof that QE is inflationary!
Nope, it isn't. The rise since QE was partly a fundamental trade (earnings have been increasing and analysts have been raising estimates, so part of the rise in stocks was legitamite) but it was largely/mostly a psychological/speculative trade.
Consider the fact that the rhetoric was nearly completely biased toward QE being 'inflationary' (and since when has the crowd ever been right?) during Aug/Sept last year. This sets up the *expectation* of an inflationary phenomena (as completely and utterly incorrect an expectation as that is). So investors decide to 'front run the Fed' by loading up on margin. Asset prices increase and the prophecy of rising asset prices is self-fufilling .... NOT because of 'inflation' but because of a margin-fueled speculative bet!
All margin bets, just like all transactions within the financial system, are horizontal. This means that for every investor who takes out margin as an asset, there is a broker/lender who must carry that margin as a liability. This means that all margin booms eventually contract. They either contract 'gracefully' by investors unwinding their bets orderly, or they 'burst' based margin calls.
Now, I am not saying that this is the 'collapse' right now. I am just saying that we are observing a margin bubble somewhere it its cycle and we have seen what the last two margin cycles did. I still think this cyclical bull market is not done (probably has a couple years left in it). I do think we are entering into a sideways zone currently, but not a crash zone. However, as this cyclical bull wears on, I think the 'margin' driver of the bull will increasingly replace the 'fundamental' driver of the bull. And thats where things will get very dangerous.