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Margin Debt, the Stock Market, and QE

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July 27, 2011 – Comments (6)

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.

6 Comments – Post Your Own

#1) On July 27, 2011 at 3:46 PM, chk999 (99.97) wrote:

The Open Market Operations can be either inflationary or deflationary, by design.

Suppose the Fed buys USTs from a member bank, they credit the bank's reserve at the Fed, and add the USTs to the Fed's assets. Where did the money to credit the bank's reserve account come from? They wrote the number down in the ledger, and poof! it appeared. The Fed's books balance because they added an asset (the bonds) and a liability (the reserve account of the bank) for the same amount.

When they sell USTs, the reverse happens and the money vanishes into thin air.

This is how a central bank attempts to manage the money supply to make the change in goods and services to attain price stability.

http://en.wikipedia.org/wiki/Monetary_policy_of_the_USA 

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#2) On July 27, 2011 at 3:58 PM, binve (< 20) wrote:

chk999,

I agree with those statements operationally, and in fact I expand on that process in quite a lot of detail here.

The problem is calling this behavior 'inflationary' or 'deflationary'. It's neither one.

Changing the monetary base does not cause inflation. The Quantity Theory of Money and Money Multiplier Models are incorrect (they are inadequate, they are semi-applicable when an economy is running near full capacity. Partially applicable models are even worse than inapplicable models).

For more of my thoughts (if you care) on inflation manfesting in our current monetary system, read this: here..

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#3) On July 27, 2011 at 4:40 PM, Frankydontfailme (27.35) wrote:

Binve. I've taken time (finally) to read through many of your blogs. First off, thanks for taking the time to write down your thoughts, they have been valuable to me and I'm sure many others.

I have one thought/question at this time. What if there is widespread corruption of the system? What if the reporting of these reserves is wildly innacurate (purposely or not)? What if these reserves HAVE, despite the laws, been used to buy risk assets?

http://www.zerohedge.com/article/exclusive-feds-600-billion-stealth-bailout-foreign-banks-continues-expense-domestic-economy- 

Do European banks have the same reserve requirments? Are they forced to buy bonds/ keep cash or can they buy risk assets?

(I get that I actually had multiple questions but I consider them of the same vein....)

Even if all of these concerns are false, we will still eventually have inflation assuming persistent deficits.

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#4) On July 27, 2011 at 4:55 PM, binve (< 20) wrote:

Frankydontfailme,

Thanks, I am glad they are useful!

>>I have one thought/question at this time. What if there is widespread corruption of the system? What if the reporting of these reserves is wildly innacurate (purposely or not)? What if these reserves HAVE, despite the laws, been used to buy risk assets?

I have no independent means of verifying that assertion. However, I just say that it seems to be unlikely. For two main reasons:

1) If you are a traditional bank (deposits, CDs, mortgages, local commerical loans) then you are not going to be speculating in the stock market with reserves anyways. You will be much more regulated. It will be much easier to see malfeasance, etc. Chances of banks in this category buying risk assets with reserves ~0.000...%

2) If you are an investment bank with a bank charter (Goldman Sachs, JPM, etc.) then you are doing all kinds of 'financial innovation' and you would be more 'able' to use reserves to buy risk assets (simply because your balance sheets is so messy and regulators have already taken a hands off approach). But a simple question is, why take that risk? There are much simpler ways to speculate. You are a bank, so you could simply loan the money (to your investment arm) into existence against your capital requirements. This is what IBs do anyways. So why use reserves to 'goose' that amount (which would be small by comparison anyways) when you could just park them in risk-free Treausries anyways. It doesn't make much sense to me to take that risk ... not that IBs always act logically. I just don't see the incentive. Risks can be taken in a more straghtforward manner.

>>Even if all of these concerns are false, we will still eventually have inflation assuming persistent deficits.

It all depends on the size of the deficit and the output gap it is trying to fill. And realize that cost-push and demand-pull inflation are very different phenemona..

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#5) On July 27, 2011 at 5:13 PM, chk999 (99.97) wrote:

I agree with those statements operationally, and in fact I expand on that process in quite a lot of detail here. 

 

I went and read that blog article. You have a very non-standard view of how things work and I don't find it convincing.

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#6) On July 27, 2011 at 6:02 PM, binve (< 20) wrote:

chk999 ,

Fair enough. But I think the 'standard' view of monetary operations is completely inadequate and misleading.

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