These days when rates are so low, it is probably more important to pay attention to overall capital flow dynamics than sometimes single stock events – another signal that macro is more important than micro.
Over the weekend, WSJ reported that the margin debt has hit record high as investors continue to double down on stocks! Democratization of investing game is finally here and leverage (which many closet indexers have simply used to make their return look better than S&P500 for many many years) is now helping retail investors.
WSJ talks about what you would expect – so many people are borrowing money to buy stock and this has been pushing the market higher and therefore investors must be concerned. At the same time, they don’t forget to mention a few retail investors who supposedly “lucked” into owning Tesla stock ($TSLA) at the right time.
While it is definitely concerning that margin debt is hitting all time time, I am not sure it means that having stock market exposure is necessarily as risky as the article perceives to be for following reasons.
While overall leverage has increased, retail investors are also hedging themselves with short index (at times 3x inverse)
Financial democratization has lowered the bar to access traditional hedging instruments – like 3x inverse ETFs. I actually like hedging my portfolio with 3x inverse emerging market ETF because 1) I want to hedge out market exposure, and 2) I want to take a directional bet that developed markets (with covid19 vaccines) will experience much faster economic recovery than developing markets (unfortunately do not have access to covid19 vaccines).
Generally, it has been the case that retail investors would only buy stock – effectively 100% LONG position – in which case there would be cascade of sell-off as all the 100% long portfolios get unwound. This is not the case if retail investor base as a whole is somewhat hedged (particularly with many of 3x inverse leverage ETFs). We must not forget that short positions help mitigate market sell-off as they become a source of demand for stocks as people close out on short positions.
Fed is now beholden to not only to pension funds but also retail investors
Fed has had to print more money to protect equity markets because they can’t let pension funds fail – pension funds have massive exposure to equity markets and given that bonds are generating next to nothing in income, sharp decline in equity market will break pension funds, which would lead to breakdown in financial system.
Now equity market, juiced up by margin debt by investors, will have further stronghold on the Fed – there is even more leverage in the system, therefore, even though retail investors are more hedged, the outcome does include catastrophe (although lower than it would have been as outlined above) and the Fed simply can’t take the risk. Fed would simply need to continue printing more money to sustain the equity market rally in my view.
What am I doing?
Ironically, this article makes me more bullish on equity market outlook in that I feel that fed now has EVEN GREATER incentive to sustain market rally, which has now become an essential to sound system.
Recently, Fed noted that the equity market is not really in bubble and allowed banks to pay out dividends – their language and messages continue to indicate that they feel comfortable with the valuation in the market.
Hedging allows you to take more leverage as you are less prone to market swings – every hedge fund is doing it and I don’t see why retail investors shouldn’t take a little extra leverage if their portfolio has some hedging instrument that can bring down volatility in their portfolio.
*not investment advice.
