US stocks are being bidded up to stellar highs by investors borrowing a record amount of money, a move which is ratcheting up concern about the risk of a sharp correction.
While the S&P 500 index hit a closing high at the end of February, margin debt (money borrowed to purchase stocks) hit a record level in January, according to data from the New York Stock Exchange (NYSE).
Margin debt now stands at $451bn (£270.9bn) on the NYSE, a rise of more than 20 per cent in the past 12 months, outstripping 2007’s peak of $381bn and 2009’s low of $173bn.
This is driving investors to question the sustainability of current valuations, especially in the biotechnology and technology sectors, and to ask whether the increase in margin debt could be a warning flag for an imminent bear market.
James Lamont, managing director and product strategist in BlackRock’s global equities team, says that margin debt is one of a large number of indicators his team tracks and that high levels of debt are always a risk and a worry.
“As long as economic and earnings growth are positive, we expect equities to deliver better returns than fixed income and this is true in the US, as well as elsewhere,” he says.
“On a relative basis, compared to other equity markets, margin debt is one of a number of factors that make us rather cautious on the US market. Note also that NYSE new issuance is also back to the 2000 highs.”
Evan Moskovit, ING Investment Management’s head of global investment grade credit, says the increase in market levels is a result of an improving economic and regulatory outlook, as well as the tremendous amount of cash searching for income and return.
“We don’t believe the market return is a direct result of the use of leverage,” Mr Moskovit explains. “‘Borrowed’ money can be utilised to take ‘long’ as well as ‘short’ positions, so looking at the level of borrowing does not really tell us anything – further analysis is warranted. Borrowing can be used in different ways.”
He is reassured by the improvement in regulation since the 2008 credit crisis, insisting that “global financial institutions have never been in better shape from a leverage standpoint.”
Old Mutual Global Investors (OMGI) says its tracking of NYSE margin debt shows that borrowed money represented 2.8 per cent of the S&P 500 index’s market capitalisation at end January 2014, fast approaching the previous peak of 3 per cent in 2007-08.
OMGI’s figures also show that mutual fund investors pulled $14bn from domestic equity funds in 2013, yet NYSE margin balances rose $80.8bn during the same period.
Hinesh Patel, strategist in OMGI’s fixed income and macro department, says: “Herein lies our main concern. If ‘borrowed money’ is now the marginal driver for the S&P 500 index, then we need to be braced for additional volatility going forward.”
OMGI is also concerned by Japan, but more sanguine on Europe. In Japan, OMGI’s analysis shows a ‘borrowed money’ equivalence to 8 per cent of the Topix index at the end of January 2014 –off the 2000 and 2006 highs of 11 per cent, but still significant.
Mr Patel says: “We see this flow as having been driven by foreign money in expectation of ‘Abenomics,’ rather than domestic participation. In Europe, we think there has been ‘real cashflow’ into domestic equity markets.”
So what should investors be doing? Mr Lamont believes the big issue is whether or not corporate earnings are strong enough to support current levels and further rises in an already expensive market, adding that investors exposed to US equities have done well and should now diversify internationally.
He says that given the S&P 500 index’s 29 per cent rise last year with only 5 per cent earnings growth, investors are betting on a strong acceleration in corporate profits.
“Investors wanting to add exposure to the S&P 500 today, need to have confidence that earnings growth is going to accelerate,” Mr Lamont suggests. “If they lack this confidence, they should be looking to add exposure to alternative, cheaper markets.”
Mr Moskovit says investors should take a long-term view and realise there is still a huge amount of pent-up demand globally.
Mr Patel sees US fundamentals as remaining attractive and that the US has the best possibility to achieve “escape velocity.” He attributes this to the energy independence story, stronger corporate balance sheets and that, for the first time, in many earning seasons, there are both “dollar in till” and “dollar in pocket” upside surprises, providing solid investment foundations. That said, he believes extraordinary factors, including margin debt, provide reasons to be cautious, such as monetary policy uncertainty and weather-impacted economic data.
Mr Patel says: “We prefer to hold absolute return funds to gain market exposure and to help reduce volatility and dampen downside potential.”
So what are fund managers doing themselves? BlackRock says it continues to invest in US companies, but selectively, and that outside the US, it sees more attractive relative valuations in other developed markets, such as Europe.
OMGI thinks 2013 marked a transition from ‘cheap money’ to ‘real money’, which has ramifications for global financial markets. This could mean that in the next phase, in spite of a better growth environment, investors may see all risk assets struggle as markets re-price interest rate risk.
Mr Patel says: “We see capital preservation as the main objective of 2014.”
Mr Lamont, however, believes the big issue is whether or not corporate earnings are strong enough to support current levels and further rises in an already expensive market.
