December 2007

The "Other" Credit Market

The “Other” Credit Market...For readers of our commentaries over the years, you already know that credit market analysis and observations have held quite the prominent place in our discussions for many a moon.  In recent years, we have suggested that if macro financial market turmoil were to finally rear its ugly head at any point in time, its origin would most likely be the credit markets.  Well whaddya know, that conceptual ship has finally pulled into port.  For now a key issue in our minds as we look ahead is just how much influence Fed monetary policy will have on non-bank US financial system trajectory and fundamentals ahead, this being ground zero for macro credit market largesse over the last decade-plus and the locus of current market turmoil.  Luckily, we're already in the midst of being presented an answer to this question.  Unfortunately, and at least as of now, three discount rate cuts and two Fed Funds rate cuts have done little to nothing in terms of influencing the literal uninterrupted bleeding in asset backed commercial paper markets, the blowout of LIBOR spreads, swap spreads, and credit market spreads of all types.  Maybe too simplistically, as we see it, the basic credit market problem of the moment is not liquidity, it's solvency and ongoing deterioration of collateral values underpinning mountains of in place leverage originally built on faulty forward collateral value growth assumptions.  So will Funds rate cut numero tres most likely to be handed down this month be the silver bullet to change current credit market circumstances?  Or will yet another rate cut ultimately prove as truly ineffective as the last two, heightening in investor perceptions the thought that the Fed is burning through precious monetary ammunition while completely missing the target?  Either way, we're all going to find out in relatively short order.

Although we continue to believe that the credit markets are the key to financial market and real economic outcomes ahead, we want to have a quick look at the "other" credit market - margin debt - for potentially important messages that appear to us to be being overlooked at the moment.  It has been one heck of a long time since we've had a peek at the history and current complexion of NYSE margin debt outstanding.  We believe it's now very important in our current circumstances to do so.  Wasting zero time, let's get right to it.  The following chart is the history of nominal dollar NYSE margin debt outstanding going back to 1990.  Of course, overlaid on this data is the like period price history of the S&P 500.  Notice anything?  
       

Of course you do.  First, and very simplistically, directional change in both margin debt balances and the S&P itself has been highly correlated over time.  No massive surprise.  Secondly, and admittedly set against the relative short-term financial market history of the last eighteen years, noticeable spikes in margin debt have been associated with meaningful tops in the major equity averages.  The coincidental spike into the final top in early 2000 is simply classic experience and absolutely obvious in hindsight.  So as we sit here today and look at our most recent circumstances, are we looking at a spike top replay in both margin debt balances and equity index price?  The spike up in margin debt balances since last summer corresponds exactly with the big run in the equity averages summer 2006 to summer 2007.  But much as was the experience in 2000, the current spike up in margin debt looks unsustainable.  So too equity prices?  We're going to find out.  Moreover, could it be that we are witnessing a cyclical peaking in margin debt outstanding right alongside a potential peak in total credit market acceleration that has been so important to US economic outcomes for so long?  Maybe not so much the coincidence.

Let's look at this same data from another angle that indeed heightens our sense of near term risk awareness.  Rather than nominal dollar margin debt balances, let's look at margin debt growth on a very simple year over year rate of change basis.  Again, we've overlaid the like period S&P 500 price experience for perspective.  Although we only show data going back a decade in this next chart, the year over year rate of change in NYSE margin debt outstanding has exceeded 60% on only five relatively short lived occasions over the last half century.  The first was in late 1972, in front of an almost 50% decline in the S&P over the following two years.   The next came about in mid 1983.  Although the equity bull market was still early in secular lift odd mode at that time, following that margin debt rate of change spike, the S&P was 7% lower one year after the margin debt number elevated above 60%.  Following on, we fast-forward to January of 1993 to again find the annual margin debt rate of change number climb above 60%.  Although there really was no equity market downturn to follow, the S&P fourteen months later had not even advanced 2%.  The final two examples over the last quarter century of the year over year rate of change in margin debt outstanding exceeding 60% lie in the chart directly below.
           

The 60% year over year rate of change demarcation line for NYSE margin debt growth was crossed literally in December of 1999.  Although ahead of the final price top in the S&P, this nominal dollar margin debt peak coincided with the top in the monthly Dow at that time literally on the nose.  The subsequent rate of change peak in nominal dollar margin debt occurred in March of 2000.  Quite the tell at the time.  In 2007, the 60% rate of change level was breached in June.  So too was June the nominal dollar peak in margin debt for now.  Although certainly anything can happen ahead, the history of margin debt relative to equity market price movement over the last half-century is suggesting to us we're at a high risk juncture right here.  This is exactly why we wanted to bring up this subject and give you a bit of historical perspective right now.  In fact, given equity market character as of late, we're quite sorry we've overlooked this circumstance until now.

Very quickly, the following chart chronicles the long-term year over year change in NYSE margin debt.  You can clearly see the five periods of rate of change spike highs in margin debt, the aftermaths of each we described above.  Of course the aftermath of the current instance is yet to be written in financial market history books.  Have no worries, you'll know firsthand how it all turns out as you'll get to live through it.  
           

Maybe more for drill than not, the following table documents equity index price performance in the 3,6,9 and 12 month periods following NYSE margin debt achieving a 60% year over year rate of change.  Will this be helpful in our current experience?  We're just going to have to see, but history is telling us to be quite mindful of risk.

Although we did not mention this above, in late 1992 the NYSE changed the methodology for calculating margin debt outstanding.  What that caused in the data was a bit of discontinuity.  And it's this discontinuity that resulted in the 1/93 annual rate of change spike in margin debt.  Should we throw out this observation of the 60% year over year margin debt acceleration based on change in NYSE methodological calculations?  We certainly could make the case for that, but we left it in this discussion in the spirit of complete coverage of all of the available data.  If indeed the Jan '93 experience is taken out of the admittedly small data sample of experience due to the data calculation change, then the S&P was lower in all nine and twelve month periods following year over year margin debt acceleration of at least 60%.  It's a message we believe is important.  

Incredibly enough, we don't hear anyone talking about these dynamics in the "other" credit market, the world of margin debt character.  We'll see what happens ahead, but at the moment the rhythm of NYSE nominal dollar margin debt relative to equity market action is raising a few warning flags from multiple viewpoints, both rate of change in margin debt and the spike in nominal dollar margin balances over the past year that accompanied the summer '06 to summer '07 rally.  As always, the most important financial market change can occur at the margin - pun definitely intended this go around.

My Logic Has Drowned In A Sea Of Emotion...It's always tough in a market like this to maintain composure and emotional stability, but indeed those are two of the most important personal characteristics of successful investors.  In order to try to maintain our own sense of balance, in periods like this we believe it's absolutely critical to remember that risk management is really the first and foremost focal point of our activities necessarily at all times.  We'll leave trying to pick pro forma short term trading bottoms to those courageously willing to test their fortunes and their will.  Although the character of margin debt circumstances of the moment is indeed a warning flag in our eyes, we need to remember that this is but one indicator of emotion.  In the spirit of continuing to watch our backs while trying to "see" what lies ahead, a number of technical tools have also helped us in the past in terms of macro risk management.  For if indeed margin debt circumstances of the here and now is truly warning of the potential for an important top, then identifying multiple corroboration points of such becomes the order of the day as we move ahead.  In relatively simple fashion, we try to look back and develop a sense of technical risk points that have fit our market environment of recent years and at least respect those points until they perhaps ultimately show us they are no longer valid.  Given that the financial markets are ever changing beasts, nothing works forever.  Nothing.  So we respect what has worked until it doesn't.  At least since 2003, one such corroboration point, if you will, has really been "staying alive at 75" that has been a big help in terms of the macro.  And by that we're talking about the 75 week moving average of the S&P 500, as is seen below.  

Certainly this is but one of many risk management tools in the greater analytical tool box, as is margin debt analysis.  As we look ahead into the new year, one big question for investors is whether the equity markets will undergo meaningful trend change given the ongoing difficulty in credit markets and clear and present speed bumps facing US consumers.  The answer to the question of market trend will ultimately be found in corroboration of directional message among many risk management indicators.

Our very best wishes to you and your families for a wonderful holiday season ahead.