Submitted by Contrary Investor. A highly recommended read.
The Spirits Are About To Speak. Are They Friendly?...And of course we are referring to “animal spirits” as you might have guessed. Time for a little compare and contrast with current cycle margin debt trends relative to past meaningful cycle equity lift off periods. You may remember that in the past we have looked at margin debt at stock cycle inflection points very much being a corroborative indicator at the birth of many a historical equity bull market. History tells us that margin debt balances bottom literally within a month or so of past major market low points. And sure enough, we saw margin debt bottom for the current cycle (so far) in February of this year – right on schedule! So, yes, at least at this point, a bottom in margin debt balances confirmed the bottom in equities. The chart below will give you a feel for exactly what we are talking about in terms of this directional synchronicity between equity market and margin debt rhythm.
Ok, trying to corroborate equity market bottoms by watching the rhythm of margin debt is fine. But what happens next? By that we mean what has been the character of margin debt growth as equity markets have continued on their historical bull market journeys? We’ve put a table of numbers together below to help give us some perspective. You know the financial media simply cannot stop trumpeting the fact that equities in general are up 40%+ from the March lows of this year. Just the kind of media taunting to make folks feel as if they are idiots for having potentially missed it. Of course the headline financial media has absolutely no recollection at all that they had been screaming buy all the way down while the equity markets dropped over 50% in the first place. Selective memory works every time, right? Anyway, to compare and contrast current circumstances to prior cycles, we went back and looked at the first 40% move of each major post recession equity bull market since the early 1970’s. We looked at just how much margin debt had already increased by the time the S&P had risen 40% from cycle lows. Have a look.
Notice anything funny? Of course you do. The current cycle is a complete anomaly relative to past experience. Margin debt balances (current info through June) have increased 8.6% from the lows. But you can see the strength of margin debt growth in prior cycles. Off the charts is the only characterization that fits when comparing this experience to the present. Who knows, maybe margin debt is about to grow parabolically for all we know. But for now what this says is that this market move is not being accompanied by animal spirits, if you will. Leverage is not the name of the game, as has been the case in past cycles. We already know this has been a very low volume rally considering the move from the bottom to the present. What this also says to us is that government/taxpayer funds jammed into the financial sector that is not being lent out is a big part of the bull market puzzle here. This unprecedented stimulus has to find a home. We saw exactly the same thing when Greenspan flooded the system in late 1998 and 1999 pre-Y2K. The NASDAQ doubled, and then summarily collapsed. The character of margin debt is suggesting to us that the levered public is not a big driver of what is happening here. It’s the momentum players, the “liquefied” bank (think Goldman, Morgan, JPM, C, BAC, etc.) prop desks, etc. that are the major drivers here. The very epitome of long term investors, right? The following chart shows us the year over year change in NYSE margin debt outstanding. As of June, the current number is still near a 40% year over year decline. We’ve drawn in black lines as to where this number has gone positive in all prior cycles. As we see it, growth in margin debt really started to be a major support to market prices when this both swung into positive territory and kept right on growing in almost vertical fashion, as has been a character hallmark of all prior post recession cycles.
So, the question becomes, when will the true “animal spirits” on Wall Street reveal themselves? It has not happened yet. And that says liquidity and momentum support for the markets is narrow and potentially volatile. Squeezing shorts and running technical stops can work well for a while. But what happens next if animal spirits broadly are not fully engaged? For now, margin debt is telling us animal spirits are very subdued. Very subdued.