The Deleveraging in the U.S. Stock Market
(May 1, 2008)
Dear Subscribers and Readers,
Our pet turtle, Snoop, just passed away earlier tonight. Over the years, both my fiancé and I had grown really attached to him. He was a perfect pet – especially since we are now living in an apartment in West LA that do not allow cats or dogs. At this point, we're still grieving – so this commentary is going to be quite short. I do apologize.
A brief observation: It is during these times when one realizes that there are many things in life that are worth cherishing in the present. Money, academics, and other materials needs and achievements are all secondary and are not important if you don't have your family or that special person to share your achievements with. This is just human nature – and this author is not immune.
Let us now get on with our commentary.
As shown on the following monthly chart, the deleveraging process has also hit the U.S. stock market in a dramatic fashion over the last six months:
Note that the change in margin debt over the last three and six months have been either below or hugging the zero line since the beginning of this year. In the meantime, the 12-month change in margin debt has also decreased significantly, although it has not completely worked off its “overbought condition” as of March 31, 2008. However, even though the U.S. stock market rose nearly 5% during April (what took the NYSE so long to publish the March margin debt data?) – based on the underlying monthly data, the 12-month rate of change in margin debt should continue to decrease significantly over the next couple of months, as long as total margin debt outstanding does not increase in a dramatic fashion. As long as the U.S. stock market does not enter a 2000 to 2002 style bear market, then chances are that the deleveraging process in the U.S. stock market is over for now, especially given the latest decline in margin rates as the Fed has continued to slash the Fed Funds rate. The next step – in order to ensure releveraging – would be for stock market volatility to calm down. This will take at least a couple of more months, but once the volatility of the stock market calms down, margin restrictions should ease – thus allowing speculators to buy on margin the more speculative/volatile stocks once again.
Thankfully – as shown in the following monthly chart illustrating the amount of cash levels in brokerage accounts – directly investable funds on both an absolute basis and as a percentage of outstanding margin debt and the Wilshire 5000 have surged to an all-time high. Given the record amount of idle cash sitting in brokerage accounts (which incidentally are only getting paid a miniscule amount of interest), and assuming stock market volatility continues to remain relatively low over the next couple of months, chances are that the conditions will be place for a substantial releveraging in the U.S. stock market sometime this summer.
While the Fed has effectively indicated that it will adopt a neutral stance going into the June 24/25 FOMC two-day meeting, this does not mean the Fed will hesitate to “step on the accelerator” again should growth continue to disappoint in the future. At this point, however, the Fed has already done as much as it can – and my sense is that it will take a “wait-and-see” approach and wait for the fiscal stimulus to “filter through” to the U.S. economy before it decides to act again. Given the Fed's current neutral stance, as well as the inevitable decline in gasoline demand this summer (the number of families that are planning for a vacation over the next six months just fell to a 30-year low as indicated in a recent survey), my sense is that crude oil prices will also soften this summer. Aside from easing headline inflation, a decline in crude oil prices will also amount to a “quasi-easing” – as businesses will see their profit margins increase and as consumers have more discretionary cash to spend on other goods and services. For now, we still have a bullish stance on the stock market and will not consider paring back unless/until most of our sentiment indicators start to become overbought.
Henry To, CFA