“You only find out who is swimming naked when the tide goes out.” – Warren Buffett

The Leverage Lesson

I remember when I was first learning about home loans, somebody explained debt to me in a way that probably sounds familiar to a lot of Australians. I was told that a mortgage would likely be some of the cheapest debt I’d ever have access to, and the argument was pretty simple: why wouldn’t you use it when “property always goes up”?

Spending 17+ years watching markets around the world has given me a different perspective on that statement. Australia has had an extraordinary experience with property over long periods, but globally we’ve also seen periods where property prices have fallen significantly. The lesson for me wasn’t that debt was necessarily good or bad. It was simply that leverage changes the equation. When asset prices rise it can amplify the outcome, but when conditions change, that same leverage can introduce risks that weren’t nearly as obvious on the way up.

That’s why the latest margin debt numbers caught my attention.

CHART 1: MARGIN DEBT OVER TIME

^{Caption: Margin Debt Over Time U.S. Market, for illustrative purposes only. Source: FINRA Margin Debt / fxevolution.com}

$1.45 Trillion of Margin Debt

The latest FINRA data shows U.S. margin debt at approximately $1.45 trillion in August. It’s a very large number historically, and when numbers like this appear in financial headlines it’s tempting to immediately interpret them as a warning about what markets might do next.

I don’t think it’s that simple.

Put margin debt alongside the S&P 500 and you’ll notice that the two have often risen together. That’s not particularly surprising. Rising markets increase account values and can coincide with greater investor confidence, risk appetite and borrowing capacity. As a result, increasing margin debt can continue alongside rising equity prices for considerable periods of time.

That distinction matters. Margin debt isn’t something I look at as a standalone indicator of where markets are heading next. What I find more useful is what it can tell us about the amount of borrowing and speculative participation occurring alongside the market.

CHART 2: S&P 500 PERFORMANCE AND MARGIN DEBT

^{Caption: S&P 500 performance over the last 30 years during booms and busts. Source: FINRA Margin Debt, S&P 500 and YCharts, as per image.}

The relationship also helps explain why leverage is worth understanding. Borrowed exposure can magnify market movements. When prices are rising, that may not attract much attention. When prices move sharply in the opposite direction, however, falling account values and margin requirements can affect how leveraged positions are managed.

We saw an interesting example of rapidly changing conditions during June and July this year. Parts of the hardware and technology market had attracted considerable speculative interest, including through leveraged products, before experiencing some very sharp price movements.

For me, that’s the interesting part of following margin debt. It doesn’t tell us what happens next, but it can help us understand the environment we’re currently observing.

Same Number, Different Story

This next chart might actually be the most important one because it demonstrates something I’ve become increasingly conscious of over the years: how we choose to measure a number can completely change the story it appears to tell.

Take today’s margin debt and compare it with the size of the U.S. economy. On that measure, margin debt is around 4.5% of GDP, depending on the GDP series and methodology used, placing it towards the historically elevated end of the range.

Looking at that chart alone, the current level certainly stands out.

But change the denominator and something interesting happens.

Instead of comparing margin debt with GDP, compare it with the total value of the U.S. equity market.

CHART 3: MARGIN DEBT RELATIVE TO GDP AND EQUITY-MARKET VALUE

^{Caption: U.S. Margin Debt Relative to GDP and Equity Market Value. Source: FINRA margin balance and as per chart / fxevolution.com}

GDP vs Market Value

Suddenly the picture doesn’t look nearly as extreme.

The U.S. equity market itself has grown enormously, so the amount of margin borrowing relative to the value of equities provides a different historical perspective from margin debt relative to the economy.

Neither comparison is necessarily right or wrong. They’re simply answering different questions. One tells us how large margin borrowing has become relative to economic output, while the other gives us context for that borrowing relative to the value of the equity market.

It’s something I think is worth remembering whenever we see a “record” statistic reported in markets.

Record relative to what?

The Warren Buffett Example

We’ve seen another version of this with Berkshire Hathaway.

There has been plenty of discussion about Berkshire holding close to $400 billion in cash, cash equivalents and short-term Treasury bills earlier this year. In absolute terms it’s an extraordinary amount of liquidity, and understandably the headline number attracts attention.

But Berkshire today is also enormously larger than the company Warren Buffett was managing 20 years ago.

If we simply compare today’s dollar amount with the cash Berkshire held in 2005 or 2006, the current figure looks enormous. Once we start comparing cash with Berkshire’s much larger asset or investment base, however, the historical picture can look quite different depending on which measure is used.

That’s not an argument about whether Berkshire is optimistic or pessimistic about markets, and I don’t think its cash balance alone tells us that. What interests me is the data lesson.

A record absolute number doesn’t necessarily represent a record relative position.

It’s the same reason I wanted to show margin debt against both GDP and equity-market value. We can take exactly the same underlying number and create two very different-looking charts simply by changing what we compare it with.

What These Charts Tell Me

When I put all three margin charts together, I don’t see a simple bullish or bearish signal. I see historically high borrowing in dollar terms, margin debt rising alongside a strong equity market, and a current level that looks considerably different depending on whether we compare it with GDP or with the value of equities.

That’s far more interesting to me than trying to turn $1.45 trillion into a prediction.

Historically, rising margin debt has often occurred alongside rising equity markets as confidence, asset values and borrowing capacity increase together. As long as that relationship continues, an elevated level of margin debt by itself doesn’t necessarily tell us very much about when market conditions might change.

What I find more interesting is what happens if that trend starts to change. If equity markets remain elevated while margin borrowing begins to contract, or if falling markets are accompanied by a more significant reduction in leverage, that would give us a different set of conditions to study. It still wouldn’t tell us exactly what happens next, but it could provide useful information about whether risk appetite, positioning and the use of borrowed capital are beginning to shift.

That’s why I’ll continue watching the relationship rather than the headline number alone.

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Until next week,

Patience. React, don’t predict.

Thomas Atkinson

CFTe | FXE Trading Academy

Trading financial products carries significant risk. The information provided is educational in nature and does not constitute financial advice.