The “Other” Credit Market
by Brian Pretti CFA, Contrary Investor. December 7, 2007
For readers of my commentaries over the years, you already know that credit market analysis and observations have held quite the prominent place in discussions for many a moon. In recent years, I've 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 as we look forward 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, 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 next Tuesday 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 I continue to believe that the credit markets are the key to financial market and real economic outcomes ahead, let's have a quick look at the "other" credit market - margin debt - for potentially important messages that appear to me to be being overlooked at the moment. It has been one heck of a long time since I've written about the history and current complexion of NYSE margin debt outstanding. 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 my 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, I'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 off 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 I 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, I'm quite sorry I'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 I 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.
|History of NYSE Margin Debt Achieving A 60% Yr/Yr Growth Rate And Subsequent S&P Price Performance|
|Month of 60% Y/Y Margin Debt Growth||S&P 3 Mos. Later||S&P 6 Mos. Later||S&P 9 Mos. Later||S&P 12 Mos. Later|
Although I 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? I certainly could make the case for that, but I 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 I believe is important.
Incredibly enough, I 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.
© 2007 Brian Pretti