The Debt Bubble Is Bursting—–Another Curtains Time for Stocks

John DVRecently I had a conversation with a large investment advisor. I recounted how I started my first fund to short technology stocks in 2002, and my second in the fall of 2007 to bet against financial companies. I told him that I would start my third fund right here, right now. This was just last week.

Sometimes I feel the stock market is a lot like that movie Groundhog Day. I wake up and find it’s the same thing over and over again. Investors, motivated by fear and greed, act the same way cycle after cycle. They’re caught holding the bag when the market falls out from under them.

But unlike the movie, we don’t need to engage in hedonism and suicide to reexamine our priorities. We just need to go against the crowd and act with conviction.

Because I do think we’re at one of those points where investors have grown incredibly greedy, and will get spanked hard in the next downturn.

One of the biggest telltale signs right now is market sentiment. There’s a number of ways to measure this, but the simplest way is just to look at what investors are saying.

As recently as February, professional advisors held on average just a 20% allocation in stocks. Since then, it’s shot up to nearly 70%.

While that’s high, it’s not nosebleed territory. It’s been higher in the past. But now the market’s been on a big run, and these guys have already upped their allocation when it’s too late. Odds favor the recent rally petering out.

We can also look at professional money managers. The percentage of domestic mutual fund and ETF allocations are at 61.1% into stocks.

Since 1980, there have been two tops that preceded major butt kickings in the stock market. Those were at 63.7% in 2000 and 63.2% in 2007.

While we’re a bit off those levels today, we’re still very close, and well above the average allocation of 43.5% during the past 36 years.

When money starts getting pulled out of the market, possibly in part to demographics as more and more people age, there’s not a lot of cash lying around to cover those redemptions. This will add further downside pressure to the markets.

But besides what investors are saying they’re doing (allocating more to stocks) and what they’re actually doing (over-allocating to stocks), there’s the mother of all sentiment indicators…

Borrowing on margin.

The thing with debt is that it works until it doesn’t.

I recently read an award-winning research piece that combined trend following with leverage (i.e. borrowing on margin).

The results were stunning. You way out-performed the market and would certainly have wealth beyond your dreams following the model since the market crash in 1929.

The problem is, using this model you still would have had periods where you lost 90% of your money. Even the most robotic trader would take issue with following a model that dipped 90% on several occasions.

Right now there’s tons of leverage in the system. A lot of people have borrowed a lot of money. So, when something goes wrong, and it will, it will result in dramatic effects to the downside. The coming avalanche will wipe out a lot of people who can’t afford a 70%, 80%, or 90% drop.

Let’s look at the numbers. Margin leverage stands at just under $436 billion. Just a few short months ago there had never been a time where nominally it had been higher. But, let’s look at recent history and put this in perspective.

In 2000, margin debt stood at $279 billion. This is a time when doctors, lawyers, and people that should know better quit their jobs to day trade their portfolios.

The next peak was in 2007. Given the short memories people have of getting smashed just a few years prior, margin debt ran up to $381 billion. It was then cut by more than 50% as stocks went south.

And now we stand at $436 billion. Could it go higher? Sure, it could. It’s been higher over the past year. However, there’s a limit to how much people can borrow. And the higher it goes, the harder it’s going to hurt on the way down.

In fact, it’s already starting to drop. This might be the most important thing to note: margin debt is falling, and has now just crossed below its own six-month moving average. This means the debt bubble could just be starting to burst.

There are also differences between 2000 and 2007 that don’t bode well for speculators.

In 2000, it was mostly technology stocks that were inflated. There were plenty of investing safe havens to avoid the bear market in technology stocks. In 2007, financials were in a bubble.

Now, there is nowhere to hide. Stocks sell at outrageous levels to both revenue and sustainable earnings. When this debt bubble pops, it’s going to be a doozy!

John Del Vecchio
Editor, Forensic Investor