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A Caution Flag

 

I’m not a registered stockbroker, and I have lost money in a wide variety of investments in my lifetime. So nobody should consider me to be an expert in financial investments.

But if Shaq can be “an expert in being big,” then I can be an expert at looking at charts.

Below is one of many charts that I keep updated to help me form the opinions that I offer in my presentations. Margin debt is created when investors borrow money to buy stocks. Increasing margin debt can be like tossing gasoline on a grass fire.

Margin Debt 4-8-13

When you borrow money to buy stock, bad things can happen if the price falls. You get a “margin call.” These are not pleasant. Whoever loaned you the money calls to say that you need to invest more cash in the deal immediately, or they will sell your stock and pay off your debt.

Under the wrong circumstances, the following event path arises:

  • People buy stock on margin, and the prices increase smartly.
  • Something changes, and prices start to fall.
  • Lenders issue a flurry of margin calls demanding more cash to be deposited in your account.
  • Enough people don’t have the cash to meet the margin call, and stock is sold.
  • The downward selling pressure causes prices to continue to fall and more margin calls.

As you can see from the chart, margin debt now exceeds the level prior to the 2000 “dot com bust” and is nearing the levels of the previous margin peak in 2007. So lots of gasoline is being applied.

Also notice the chart documents how the Dow performed both one year and two years after the peak in margin debt.

In the dot com era, margin debt peaked in March 2000 with the Dow at 11,234. A year later, the Dow was at 9,106. Two years later, it was at 7,415.

Margin debt peaked again in July 2007 with the Dow at 14,021. A year later, the Dow had fallen to 10,827, and two years later it was at 8,087.

We are in an era of unconventional monetary policy that will result in unintended consequences that are difficult to predict. When interest rates are kept too low for too long, bubbles are likely to form. These bubbles can occur in stocks, bonds, real estate and commodities.

We are quickly getting back to the 2007 discussions of “musical chairs.” At the time, investors knew bubbles were forming but planned to stay invested “until the music stops.” Then there is a scramble for everyone to find a seat.

Reprint from the blog of recenter.tamu.edu      by Mark Dotzour

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Categories: Uncategorized
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