"This Week Will Be Bad" - Margin Calls Mean More Pain To Come

Authored by Andrew Zatlin via Moneyball Economics,

Market Likely to Drop a Bit More on Margin Calls

Still Bullish, but this Week will be Bad

This week, we will probably see more pain as the margin calls roll in. Or as it is often called, leveraged positions get unwound.

In case you are unfamiliar with leverage (margin) here's a quick primer.  I'll simplify a bit.

Suppose that you own $1M in stock.  An investment bank will lend you up to 50% of that underlying  stock value, in this case $500K.  You plow that money into the stock market.

There's a solid reason for doing this.  Suppose the market rises 5%.  That extra $500K you borrowed generated an extra $25K in paper profits.  Since you have a liquid value of $1M, that's an extra 2.5% you generated.

(And if you are a money manager, you look like a genius to the unaware.  If the market grows 10%, then you generate an extra 5%.  And you turn around and brag to your clients that you earn them more than the stock market.  And you bag big bonuses for beating the market.  Except you neglect to say that your genius has nothing to do with stock picking and everything to do with borrowing cheap.)

Then bad news: the market drops 5%.

You get a call: your $1M stock is now worth only $950K.  The lender can only allow you to have a loan of $475K, and your loan is for $500K.  Problem part 2: that $500K loan also dropped 5% and you are down to $475K.

The lender feels very sorry for you, sends you a ghost hug emoji (it's a hug that you can't feel but you know is there).  Unfortunately, you have 1 day to pay back the $25K.  It's the law and if you don't get them money by close of business, they will liquidate your stock until they get the $25K

You've had paper gains and paper losses, depending on the ebb and flow of the market.  But now your paper loss is going to be a real loss.

You aren't allowed to ride out the loss: the loan is due in part TODAY.

You have what retail investors know as a margin call.

The term for this situation - extending your market position by borrowing against your existing liquid value  - is called leverage.  And the recent drop in the market means that investors are now over-leveraged.

Forced selling is the meme for the day.  Fire sales will be underway.

But wait - it gets worse.

You have 1 day to replace that $25K.

Except now everyone is scrambling to sell to cover their shortage.

The market falls another 2%.  Your $1M is now worth only $930K and the bank needs $35K.

More selling.

This is why the deep selloffs typically go even deeper.  Fire sales.

One more twist: Bonus Season

November is when money manager performance gets reviewed and bonuses set.

A lot of them are selling off to lock in profits.  Maybe they were planning on selling a little bit - but with the recent blowoff, they might feel like selling more than that.  It adds a bit more downward pressure.

There is a mad rush for the exits right now as investors meet margin calls.

Bitcoin dropped 5%, for example.

People were exposed and suddenly need cash. NOW.

Still feeling Bullish, But a Tad less so

Blood in the water always means buying opportunities.

Given the liquidity pressures of margin calls, I hesitate to jump back in today.  It's likely the Fed Plunge Protection Team is watching to prevent further rout.

(Trump certainly doesn't want a drop this close to an election.)

As for targets, I note that tech stocks have been crushed 20% or more from their recent highs.  I avoid hardware companies because there is a global slowdown there.  (AMD is seizing massive share from INTC because INTC is having factory production problems and PC companies are turning to AMD.)

The reason I am less Bullish is that I am seeing the trade wars start to affect the US.  That is, I am seeing signs of slower demand for US products.  And the core thesis for being Bullish is that overall the US economy remains pretty strong.

Keep your powder dry and wait for the end of the sell-off before making a move.