Mirror Mirror on the Wall - Does Margin Debt Predict Them All?

Recently, I was reading an article that was began discussing the record levels of margin debt on brokerage accounts. It made a deft point that record levels of margin debt “is a red flag that the market is over-inflated by speculation”. This is a bold statement; however, it is on the right path. Let’s take a deeper look into what they might have meant by that statement and what it may mean for today’s markets.

Since 1970, on a monthly basis the NYSE has been reporting the aggregate debits in securities margin accounts in which they kindly organized into tables and excel sheets. The chart below shows this data since 1996 plotted with the S&P 500 cash index.


As you can see in this chart, the margin debt (in $ mils) and the S&P 500 have a very closely related relationship. The record margin debt in February 2007 was $295,870; whereas the previous record was $278,530 in March of 2000. Is it a coincidence that the previous record was also at the peak of the dot-com bubble just before the markets began to crash? Maybe so, but I wouldn’t bet the farm on it.

The most logical reasoning/theory behind the close relationship (if you look at it, their activity almost mirrors each other) is that when the market is racing higher, market participants want in on the action and therefore leverage their brokerage accounts to take advantage of the rally. A high amount of margin debt also means there is a high level of bullishness. On the flipside, margin debts decrease as the market retreats due to a plethora of margin calls and participants having to get out of the way of an incoming steamroller.

Margin debt can be healthy during bull markets as it provides fuel for further market gains. The problem comes in when excessive speculation comes during a “false” bull market, which is where I believe we might be right now (the latest retest of the highs since Feb. 27th is a false rally in my opinion). The pitfall is when a steep decline in stock prices exposes investors to margin calls, requiring them to post additional collateral or sell securities resulting in even steeper declines such as February 27th, 2007. With so many questions in the marketplace; housing, inflation, interest rates, credit tightening, a weakening U.S. economy, trade deficits, budget deficits, weakening dollar, higher energy and commodity prices and equity markets at or near all-time highs, one has to wonder if a decrease in margin debt is necessary to bring the market to less prone levels.

At these levels, a doomsday may not necessarily be in the works, but it does make me wonder how long or how much higher both margin debt and equities can go. Since they mirror each other so closely, both of them are important to watch. At the same time there is a second voice in my head that tells me to be weary of false rallies in the market and to look for opportunities to hedge positions. As always, I hope you enjoyed the read and let’s see where the next few weeks take us. Tomorrow is the release of more inflation data (Produce Price Index) and it will be a market moving event. Which direction the market will go next is anyone’s guess. To paraphrase the JP Morgan, the only thing I know is that the market will oscillate with incoming data and news.

Sources: NYSE, eSignal

Market Analysis

The early part of this week seems to be void of any major economic data releases. However, it is the beginning of earnings season (led by Alcoa’s $0.79/share gain, $0.03 ahead of analysts expectations) and a key inflation report is due on Friday morning. Last Friday’s job report reported an unexpected 180k increase in nonfarm payrolls and a 4.4% unemployment rate, which is low enough to raise concerns about insufficient labor supply and rising labor costs. Since inflation has been a key headache for fed officials, I thought it would be prudent to talk about inflation today.

The continually strong commodity prices we are seeing across the board from heating oil to wheat will certainly have an affect on inflation concerns. The trickle down effect of higher commodity prices may lead to higher inflation, a worried Federal Reserve and a multitude of other problems for the weakening U.S. economy. Before diving into the discussion, let’s take a look at some of the commodity price charts. There are quite a few, but just take a look at each of the price trends. I have taken monthly charts from a basket of commodities from the agricultural, metals and energy sectors.

Aluminum
Copper
Corn
Gold
Heating Oil
Live Cattle
Oil
Wheat

As you can see, each of these charts points have the same trend over the pas 5-8 years; significantly higher. This basket of agricultural commodities, energy products, and base metals has increased substantially. Take a look at the price increases in percentage terms since 2000:
· Aluminum: +88.22%
· Copper: +357.41%
· Corn: +86.5%
· Gold: +135.52%
· Heating Oil: +210.50%
· Live Cattle: +43.37%
· Crude Oil: +132.32%
· KC Wheat: +65.86%

Those numbers make me wish I would have been invested in a basket of commodities from 2000-2007 during the time the S&P 500 has been flat. Either way, I believe these trends could continue in the near future because of strong demand, weather storms disrupting supplies and a general need for commodities. As commodities guru and world traveler Jim Rogers might say, “We are in the greatest commodity bull cycle our generation has seen”

The question is whether or not commodity prices and inflation can be linked. When considering the relationship between commodity prices and inflation, commodity prices have a positive correlation with inflation. Prices can be argued to be a leading indicator as they are quick to reflect economic changes in supply and demand. The resulting higher prices we see today compared with even 2-3 years ago is tremendous and will eventually be reflected in the final product purchased by consumers; and therefore, higher inflation.

Arguably, crude oil prices (and therefore energy prices) have a robust history of influencing inflation measures the most. As all of the commodities I looked at are currently priced within the top quartile of their six year highs, it makes me wonder how much further prices can reach before negatively affecting the economy (that is, more than it has already). Crude oil will be the most influential as prices seem to be supported be a continuation of global tensions with oil exporters and world demand increases.

The Produce Price Index (PPI) will be released on Friday morning. The consensus estimate is for a 0.8% increase in the headline number and a 0.2% increase in the Core PPI. With that said, I would not be surprised to see the core PPI come in slightly hotter than expected given the deluge of higher commodity prices across the board. As the Federal Reserve seemingly reiterates its hawkish tone on inflation, this number could signal a short-term direction for the market.

Capital Spending Whoas

Lately, I have been writing about the market’s latest push toward the highs as a false rally. Maybe it’s just my nature to scrounge around looking for evidence to support my contrarian views, but I am adamant about backing up my opinions. Most recently I said the reaction to the FOMC policy statement was overblown as traders and investors misread the policy to the effect they saw a rate-cut in the near future. To the contrary, the statement had obviously stated that it plans to maintain the current fed funds rate at 5.25%. The markets react and anticipate, yet sometimes they anticipate incorrectly. This is why we are so fascinated with financial markets and this is why things can become ugly in a hurry.

I don’t believe things will get ugly, but I do think the markets have been overlooking certain aspects of the economy that are suggesting weakness, yet are captivated by other aspects in order to keep the “Goldilocks Scenario” alive. Eventually, according to efficient market theory, all information will be accounted for and the market will price accordingly. That said, the markets should currently be pricing in a modest economic growth of 2-2.5%, slower corporate earnings, higher energy prices, a slowing housing economy (which by the way pushed economic growth for the past several years) and a federal funds rate of 5.25%. However, I don’t think we have seen this. The market is sitting within 1-2% of their 6 year highs and nothing is being discounted. An extremely optimistic market will sooner or later catch up with the real information being released leading to less optimistic markets with a sense of risk.

One of the aspects of the economy the market has simply overlooked is the slowdown in capital spending. Capital spending is the capital spent to acquire or upgrade assets. Think buildings, computers, planes, trucks, equipment and other machinery. Before providing the numbers, let me explain why capital spending is important. When businesses are growing (and the economy expanding), they need equipment and machinery to let their business flourish. Orders are placed with vendors to provide the products and then the businesses begin producing their goods for consumers. If they decide to not invest in their infrastructure then they are not producing more goods; therefore, the economy has fewer goods on the market and it slows the overall business cycle. This is an elementary crude explanation, but it should do for now. On to the numbers.

This morning, the numbers for February factory orders were released. They did nothing to make me believe that the downtrend will be interrupted by a sudden surge of new orders being placed. The first quarterly decline in capital spending in nearly four years was posted in the fourth quarter of 2006, but it passed with hardly a mention. Although Feb. orders were up 1.0%, this was well below the consensus estimate of a 1.9% gain following a -5.7% drop in January orders.

This doesn’t bode well for the overall expansion of businesses growth. Take a look at the chart below. You can see that the drop has the look of the drop in orders from the last recession in 2000.

Factory orders consist of durable and non-durable goods. Non-durable goods
include items like food, clothing, and tobacco products. Durable goods are
products that maintain non-durable goods such as washers and dryers, computers
and machinery.

The drop in capital spending is happening at a time of near-record corporate profits. It has been known for some time that CEOs remained cautious in their spending plans, yet they have spending all those profits on share buybacks. That creates some shareholder value, but how does that help an economy that is beginning to show more signs of weakness?
Ben Bernanke has taken notice of the lack of spending by businesses hoarding cash as he gave his testimony to the congress last week adding that there was “an additional downside risk” to the economy if the weakness in business investment continued. I know we have ignored some weaker data points along the way to these multi year highs, but this is not something that we want to ignore.

The lack of spending may have similar effects on the economy as a weaker housing market. It will take some time to see, but as early as next month more capital spending data will be released. Another quarterly decline would mean two consecutive quarterly declines in capital spending at the same time the economy is modestly expanding. Take note that the market has yet to account for this and it again overlooks a vital piece of forward-looking information reflecting the state of the economy. I have not forgotten the 6.5% drop near the beginning of March; however, it took the market no more than ten trading days to recover almost all that was lost during that “correction”. That is not convincing enough for me and the wall of worries is continuing to grow. Maybe I am overly cautious, but I doubt it.

Friday Slough

It is Friday afternoon and the market's have again been very volatile. It was a strong start this morning as the marktes received a deluge of solid data; consumer spending defies the economic slowdown, incomes are up, and the Chicago PMI set a whopping record, jumping from 47 to 63 (largest historical monthly jump); however, inflation (Core PCE) was up 0.3%, or 2.4% yoy (about as expected).

The Chicago PMI number is what is surprising. How does the manufacturing index jump so much in a single month? Was it extremely warm in Chicago in March? Possibly, but we still don't know why this came out so hot.

The morning news crossed the wires and the selling began shortly thereafter when the US government posed tarriffs on Chineses importing paper goods (10-20%). That will mean higher prices for Chinese importers, yet it also means that we are trying to cut into the trade deficit with China. In fact it is interesting to note:

"The action reverses 23 years of U.S. trade policy by treating China, which is
classified as a nonmarket economy, in the same way that other U.S. trading
partners are treated in disputes involving government subsidies."

Oh well, life goes on for the Chinese. Life goes on in America. As the markets are holding steady near the breakeven point, I don't see a whole lot of change happening near the end of the day, unless of course traders decide they don't want to hold on to any long positions over the weekend (could be likely) with geopolitical tensions as they are and oil prices continuing to hover near YTD highs.

That's it for today and I hope everyone enjoys the weekend. I am headed off on a six hour drive to southwest CO to Silverton, CO. I'll leave you with this.

"One Lift Servicing Heaven" Silverton, CO (www.silvertonmountain.com)

My Other Blogs

I have been writing for almost a year, but mostly for two other blog groups. One is David Kosmider's www.stockweblog.com and the other is Aaron Day's www.commoditytrader.com. Both of them have some great market insight for investors, traders and anyone interested in learning about the markets, but I have decided to start my own blog where I can express my thoughts a little more freely. If I feel like talking about something other than the irrational markets, I can go ahead and post about that damn weekend trip to Silverton, CO (actually, I'm going this weekend and can't wait).

Anyway, here is a link to the articles I have written for these two websites. Enjoy the read and leave me a few comments if you think any of them are itneresting. All of them are more technical than I plan on writing here.

Rocking Wall Street

Gary Marks is by no means average, let alone another average hedge fund manager। Marks is a successful musician, and you can see the unique approach he has to the investment industry when he shows up to give market commentary to CNBC while wearing a blue bandanna. In fact, from the pictures that i’ve seen, he looks like he’d fit in quite well in Sturgis. He has taken his music background and developed a unique approach to the hedge fund industry since 1999. As incomparable as Marks is to anyone else in the industry, when I was recommended by “the humble analyst” John Mauldin to read “Rocking Wall Street” written by Gary, I had to jump in and immerse myself into the book.

”Rocking Wall Street” is not for the average reader, no investor। It is directed toward the high net worth individual who is not conecrned with fickle everyday purchases. Instead these individuals are looking to generate returns with their capital for retirement and even looking for capital preservation for generations to come.

First, a little bio on Gary Marks। Marks is highly regarded in the investment industry. In 1999, he began a hedge fund of funds firm called Sky Bell Asset Management which he still runs as CEO. Today, he is a multi-manager specialist and has assets under management of over $300 million, a respectable size, but still small compared to some behemoths. He has also excelled in the music industry, most recently releasing his 10th CD, “A Whisper Can Change the World” in February 2007. He has taken his lessons in the music industry and transposed them to the hedge fund industry by creating a unique approach to preserving capital and investing with other managers.

His book is written in an extremely one-on-one manner as he provides insight from his daily routines and interaction with clients। The book is based on four main strategies:

1. Emotional Controls
2. Knowing the Difference Between Market Stats and Market Hype
3. Hedged Portfolio Construction
4. Planning for the Future and Seeking “The End Game”

Throughout the book, Marks uses his personal experiences with clients and combines a narrative over these conversations. His explanations on each interaction with clients provide a real-life insight into what goes on behind closed doors of a fund of funds manager and how intricate the process can be due to personality differences in client-manager relationships. Marks walks the reader through hedge fund definitions, diversification, and portfolio construction for the high net worth individual (although this can be transferred to the everyday investor if you read between the lines). One of the most effective “scared straight” tactics he uses throughout the book is the debilitating effects of losses vs. gains.

For example, if you return 50% on $100,000 you have $150,000. But if you
lose that same amount (50%), all of a sudden you are left with $75,000 or a 25%
loss even though the percentages never changed. Losses are difficult to
overcome, yet that is the nature of the business.

As marks continues to educate the reader delicately, he leads us to “The End Game”। Essentially, this is when an individual has reached a point in his/her life where they have enough capital to live a very high standard of life. They have enough capital to not take certain risks even though a loss of X amount of capital or a double up of X amount of capital would not change their lifestyle. This individual has reached “The End Game”. At this point, the individual should be looking for capital preservation and to provide for generations to come (if that is the choice the individual makes). It is an interesting point and one that is too often overlooked as we see American’s trying to keep up with the Joneses.

Gary Marks continues to excel wherever he puts his mind to work. Whether it be managing client’s capital creating musical works of art or even writing though-provoking books. He has integrated several skill sets into the financial industry and into a book that is a reasonably easy read for anyone with a financial background. Many people will look at this book as biased toward a select few high net worth individuals in the world; however, while reading this book I found it a great look into the inside track of what has been called the sexiest industry in the financial world. Derailing all traditional rules for success in the financial industry, Marks makes his mark.

Jim Cramer Shoots Himself in the Foot With Another Wacky Interview

It seems as if everyone now knows who Jim Cramer is; host of CNBC's cult-like show, "Mad Money", co-founder of TheStreet.com and a former well-known hedge fund manager. If you haven't noticed, he is extremely adamant about letting the smaller investor play with the big boys. But if you haven't seen this clip of Cramer on the show, "Wall Street Confidential", then you have missed out on his hypocritical comments (click here to see the 10 min clip).

I am miffed about how this guy could go on TV and actually say some of the stuff that he says. First of all, any person could go out and pick a portfolio of stocks and do as well as many money managers in the investment wolrd that get paid to do it. I'm not saying that the average person is as good as the professionals, but financial markets are fickle and can make a genius look average and an average person look like a genius. It's the nature of the game.

However, Cramer takes it several steps further. In fact he gets on a TV show, Wall Street Confidential, and essentially pleads guilty to stock manipulation.

"You know, a lot of times when I was short at my hedge fund—when I was
positioned short, meaning I needed it down—I would create a level of activity
beforehand that could drive the futures. It doesn't take much money. Similarly,
if I were long, and I wanted to make things a little bit rosy, I would go in and
take a bunch of stocks and make sure that they're higher. Maybe commit $5
million in capital, and I could affect it. What you're seeing now is maybe it's
probably a bigger market. Maybe you need $10 million in capital to knock the
stuff down.

But it's a fun game, and it's a lucrative game. You can move it up and then
fade it—that often creates a very negative feel. So let's say you take a longer
term view intraday, and you say, 'Listen, I'm going to boost the futures, and
the when the real sellers come in—the real market comes in—they're going to
knock it down and that's going to create a negative view.' That's a strategy
very worth doing when you're valuing on a day-to-day basis. I would encourage
anyone who's in the hedge fund game to do it. Because it's legal. And it is a
very quick way to make money. And very satisfying.

By the way, no one else in the world would ever admit that. But I don't
care. And I'm not going to"

Jim Cramer said it's illegal, but in fact this is ludicrous. Yes, it's legal
in the sense that anyone can go in and short a stock or bid a stock up, but then
he continues to say something that is in fact, illegal:

"Now, you can't "foment." That's a violation. You can't create yourself an
impression that a stock's down. But you do it anyway, because the SEC doesn't
understand it. That's the only sense that I would say this is illegal. But a
hedge fund that's not up a lot really has to do a lot now to save itself.

What I used to do was called— If I wanted it to go higher, I would take and
bid, take and bid, take and bid, and if I wanted it to go lower, I'd hit and
offer, hit and offer, hit and offer. And I could get a stock like RIM for
maybe—that might cost me $15 to $20 million to knock RIM down—but it would be
fabulous, because it would beleaguer all the moron longs who are also keying on
Research in Motion.

So we're seeing that. Again, when your company is in survival mode, it's
really important to defeat Research in Motion, and get the Pisanis of the world
and people talking about it as if there's something wrong with RIM. Then you
would call the Journal and you would get the bozo reporter on Research in
Motion, and you would feed that Palm's got a killer that it's going to give
away. These are all the things you must do on a day like today, and if you're
not doing it, maybe you shouldn't be in the game."

Now why would you say such a thing? Why would Jim Cramer, who has a cult-like following from his tv show, say that he attempts to manipulate a stock price because he needed to make money. Yes, Wall Street is a cut-throat game, but to admit this on TV could be a bad move. Actually, he admitted that this was a bad move. From his website, he issued an explantion (click here) that "when I was a hedge fund trader in the 1990s, I played fair, and I did nothing that violated those laws." Yet if you scroll back to the beginning of this article, you notice that he in fact admitted to doing such things as "You know, a lot of times when I was short at my hedge fund—when I was positioned short, meaning I needed it down—I would create a level of activity beforehand that could drive the futures. It doesn't take much money. Similarly, if I were long, and I wanted to make things a little bit rosy, I would go in and take a bunch of stocks and make sure that they're higher."

I have a lot of respect for Jim Cramer as a trader, but I have no respect for him as a TV figure and the manipulation that he has on everyday investors. It's almost a sick game to him. "Hmmm...how many people can I manipulate in this world without it affecting my everyday life. That sounds like fun today." Instead, listen to your guts and not some guru who has admitted to and denied manipulating stock prices in the same week.

Until next time, Enjoy the show!