Margin debt and how I was wrong

A man must be big enough to admit his mistakes, smart enough to profit from them, and strong enough to correct them. - John C. Maxwell

I was wrong. There, I said it.

Over the past few years many market technicians (including myself) were looking at the continuously increasing new highs in margin debt as a warning sign stocks were topping.  In retrospect and having a different perspective I have concluded we were wrong.

There is no arguing, margin is fuel to the bull market fire. For those not aware, when investors/speculators run out of their own money to invest, they can borrow from their brokerage institutions against a portion of their brokerage account. As long as they can make more money than the costs to borrow it can make sense to use margin.  The times it becomes a problem is when those same investors/speculators have 1) reached their borrowing limit or 2) if stocks decline. If investors have no more money to invest (whether from their own sources of funds or borrowed on margin), the market runs out of buyers and can go no higher. If stocks decline margin investors are forced to sell positions to pay off the outstanding margin debt which is being demanded from their broker. Since they have no remaining liquid funds (all funds are fully invested) this forced liquidation adds more sellers which of course, drives the market down even further.  And on it goes, potentially snowballing. Where the level of margin debt really matters is that the greater the margin debt, the greater the possible decline.  

Back to being wrong … My view had always been because margin debt reached a new high it could not go higher and so stocks had to decline. As it turns out that thinking was completely wrong and where I should have focused my concern was not at whether it was making new highs (because that is actually very bullish) but rather if margin debt CHANGES DIRECTION and starts to decline.  Going higher has the effect of pushing prices higher, falling margin has just the opposite effect.  It seems so simple now, what the heck was I thinking?

This leads me to this week’s chart which is that of a historical look back at margin debt updated through the first quarter of this year.  The red line is the US Stock market (SP500) and the blue line is margin debt.  What I would hope you take away from this chart is at least the following

1)    Rising margin debt = rising stock prices

2)    Falling margin debt = falling stock prices

3)    Peaks in margin debt have coincided with peaks in the stock market

4)    Margin debt peaks first

Now you have that firmly ensconced in your brain, ask yourself this, “is the decline in margin debt from the start of this year a temporary blip or the start of a new trend?”  Don’t know the answer? Me either but I do know this, it is not the time to be attempting to be a hero and taking on excessive risk.

The bond market is talking, are you listening?

There is an old investment adage that says the bond market is a lot smarter than the stock market.  What they mean by that is bonds tend to lead and stock follow. As such, wise stock investors know it pays to watch what the bond market is doing.

 What I like to do is watch for changes in the bond market investor’s risk appetite. It makes sense to me that if bond investors in are allocating the bulk of their money into the highest risk bonds (“junk”) as compared to the least risky (US treasuries) you can reasonably assume safety is not their main concern (“risk-on”). In this risk-on environment, it follows that stock investors are also more comfortable with over-exposure to the stock market. If the converse is true and bond investors are more risk averse (“risk off”) and shifting their money into US treasuries, stock investors should pay attention and consider appropriate action.

 The chart below, a ratio of high yield bonds (riskiest) to US treasuries (least risky), provides a historical snapshot of bond investors risk willingness over time. As you would expect values of this ratio move up and down but like all investments but it’s when values are at extremes there is reason for action. As you can see we went into January of this year at the 2nd highest level seen in the past 10 years.  Just as importantly since the start of the year, we have formed a topping pattern and have since begun to break down. I want to draw your attention to one last fact which is there have been 3 times in the past when this ratio was overbought and created a divergent high and I have noted those times with the dotted red vertical lines. What is important about these points is that each time it has occurred stocks (see lower pane of SP500 price) followed with a double digit decline. The 2008 correction was a ~56% waterfall, the 2010 correction a ~16% drop and finally the last time it occurred in 2011 stocks declined ~18%.

 You can see we have this same set up right now, today.

It may be a bit too early to tell but what’s the odds the smart bond market is wrong this time?

Followin' the Money

Followin' the Money

Because mainstream media uses the SP500 or Dow Jones Industrial average as their proxies for the US stock market, most investors don’t know about XII, the institutional index. The NYSE Institutional Index (XII) is a capitalization weighted index of 75 stocks most widely held equity investments among institutional equity portfolios. If you are managing money and making investment decisions based upon market movement I would posit watching this index is more valuable.

Since it is estimated that institutions manage between 80-90% of stock market assets it makes perfect sense to watch what they are doing and insure you are NOT going against their movements. Doing so for long periods can be disastrous to one’s portfolio.  Since they make up the majority of the market, they dictate its movement.

Below is a chart of the institutional index over the past 26 months. As you can see it has been in a very nice uptrend and, up until December, price has carved out a series of higher highs and higher lows which is the definition of an uptrend.  The good news right now is index is still bullishly configured but there are some reasons for concern. Firstly, our momentum indicators (in the top and bottom panes) are pointing down which reflects a slowing price.  Slowing price by itself is not the issues, it’s what happens after that matters.  If momentum continues to fall, eventually prices will follow along. For now what has happened is the slowing momentum has caused price to make no progress higher for the past 4+ months. You can see each time we attempted to breakout higher we stalled out around the same level.  From a market internals standpoint this tells us there aren’t enough buyers to overwhelm sellers and as such, price remains within a consolidated trading range (highlighted red area) until more buyers step in.

Consolidations should be looked at as a necessary breather to any trending market (up or down). Think of it as a runner who slows down to hydrate and refuel. Sometimes that is just what the runner needs as he builds up additional energy to continue on. Other times, the runner has spent all his energy and no matter how much hydration and refueling he gets, he is done. The market is at that stage right now. Prices will continue to chop around until buyers and sellers settle their current impasse. To continue the bullish trend, prices will need to break above the consolidation area  (828) and hold for me to be willing to add more exposure to the market. If, on the other hand, prices break below the consolidation area (805) and more importantly, below the lower blue trend support line and prior low (790) , this is warning that “big money” is selling and it would best to think long and hard if going against their actions is in your best interest.

April 29, 2014 - Household debt

I was traveling and apologize for the late post but bad weather (Arkansas tornados), remote location and delayed travel hindered me from actually being even a little productive. As such this week’s blog post is not from me but rather a recent one Tom Mclellan posted which I thought was quite interesting and definitely worth watching going forward. If you have not visited his site or aware of his work, I would encourage you to dig a little deeper at www.mcoscillator.com

Debt is bad, at least for you and me.  But debt held by others can be a wonderful thing, as long as it is increasing. Debt is only a problem at the point somebody decides to do something about it.

The unfortunate fact for stock market investors is that household credit market debt as a percentage of disposable personal income has been shrinking ever since the peak back in 2007.  Normally it is bullish for stock prices to see household debt increasing, and bearish to have household debt decreasing.  But occasionally the two can go in opposing directions, which is the condition we see right now.

Historically when such a divergence has happened, the stock market eventually realized that it had wandered off track, and it worked extra hard to get back with the program.  But here we are, almost 7 years into a decline in household debt versus income, and thus far the stock market shows no sign of recognizing its off-track condition.  It is a bigger and longer divergence that we are accustomed to seeing in past episodes, such as those labeled in the chart.  The most likely explanation is that the Fed is helping to push up asset prices, in hopes that such action will eventually help push down unemployment rates and other indications of economic malady, and that this action by the Fed is continuing the divergent condition much longer than normal. 

The Fed's data on household credit market debt only extend back 62 years, which is just barely one interest rate cycle period, but is still a pretty long period of time.  And in that time, there has never been an instance of stock prices moving up while the debt to income ratio moved down that did not resolve itself by having stock prices moved hard downward to get back on track.  I do not see it as good news that the stock market is now going for its longest divergence ever in this regard.  I instead see that as a sign of trouble that will eventually have to be paid back double once the reckoning commences. 

It is understandable at this moment in history that we are seeing debt decrease, or perhaps I should specify PRIVATE debt.  U.S. government debt, on the other hand, has doubled in the past 8 years.  Through either willful action or neglect, Congress has been taking up the slack in the debt market.  But while Congress is still on a spending spree with other people's money, Baby Boomers are facing retirement from an ever closer vantage point, and realizing that piling up 2nd and 3rd mortgages on McMansions is not a great way to prepare for the day when the paychecks stop coming.  So they are doing the wholly rational action any reasonable person would do, increasing their savings and reducing their debt. 

The big problem, though, is that there are a whole lot of us Boomers trying at the same time to reduce our debt and get ready for retirement.  The "echo boomers" and millenials are not feeling any compulsion to take up the slack.  They would rather live in Mom & Dad's basement than take out their own mortgage to relieve the Boomers of those McMansions, which leaves the housing market moribund, the banking system seeking yield wherever it can find it, and the Fed trying to fill the void with free money.  So far that has not reached a trigger point that would cause the stock market and the banking system to reverse course, but I have to figure that such a reckoning day is coming.  It always has before, eventually.  And if the crude oil leading indication is right, it could take until 2018 before that reckoning point will appear and start to matter. 

Ironically, if Congress ever decides to mend its ways and step back from the ever-increasing debt levels, then history shows that the stock market could be in for real trouble.  As long as we are spending somebody else's money for whatever we want, the party goes on.  The only time that the problem manifests itself is when somebody tries to do something to solve the problem. 

April 21, 2014 - AD Line

From a market technician’s aspect there is only one thing that matters and that is price as it reflects all known information.  Most newcomers to the market can find interpreting price movement ethereal and as such attach mystical significance to indicators because they come with better “instructions”, provide simple buy-sell signals and, in general, require a lot less experience to manage.  Sadly though, the Holy Grail of indicators does not exist. That being said indicators are extremely helpful and can provide additional depth to market analysis than just price provides.  I find one without the other is like peanut butter without jelly, bananas, or chocolate.

One of my favorite indicators when looking at the health of the overall market is the Advanced-Decline line, or AD line for short. The AD line measures market breadth or simply the sum of the number of advancing stocks minus the number declining in the NYSE index.  It’s such a clean and simple concept because for a market to move higher the number of stocks moving up has to be more than the number moving down over time.  The AD line is a leading indicator meaning it moves ahead of market price. For example when the market is moving up and a correction is coming, the AD line makes the first move down as more and more stocks begin to fall. The market won’t actually begin its fall until the number of stocks going down eventually overwhelm the number increasing. Market strength is undermined when fewer stock participate in an advance.

Don’t let all this talk about the AD line and market falling leave you the impression the AD line is only good for warning of potential declines, it is in fact an equal opportunity indicator working equally well warning of potential rises or declines.

Let’s take a look at the current AD line and see what the health of today’s market.  In the 80-month chart below I have plotted the AD line in the top pane and a US stock market proxy (SP500) in the bottom. You can see the AD line began moving down in January of this year while SP500 price continued to move up during the same period.  This reflects fewer stocks moving up but because the total falling have not yet overtaken the number increasing, stock market prices push higher.  This (negative) divergence is a warning flag. To provide some historical references and why I find this indicator so persuasive, I have highlighted all prior negative divergences with blue vertical bands to help illustrate what happened subsequently.

While not reflected in this chart, there are times when the AD line warned of a change but the market never followed along. Contained within this back-tested period the AD line does a good job warning of potential market reversals but the exact timing and magnitude are unfortunately left undefined. Regrettably there is no perfect indicator and the AD line is no exception but when used to confirm price it can do wonders to keep investors on the right side of market trends.