In a May 24, 2007 commentary titled “Leverage, Leverage, and more Leverage” (four months before the peak of the last bull market), I emphatically stated: “Despite what the mainstream media says, there are now signs that liquidity conditions are deteriorating … Make no mistake: This “pillar” of liquidity [subprime lending] of the U.S. housing market has fallen and will have a depressing effect on the U.S. housing market and on U.S. households’ liquidity for many years to come.”
By early October 2007, I was discussing why I was short the U.S. stock market and why investors should be trimming their equity long positions.
We believe there are 3 distinct pillars to superior investment performance: 1) Investing in non-correlated strategies (e.g. Japanese stocks in the 1960s and 1970s), 2) the ability to find inefficiencies in selected markets (e.g. private real estate or the ability to influence markets, such as that of PIMCO), and 3) recognizing shifts in investment regimes ahead of the curve, and adjusting one’s asset allocation or investments accordingly.
If an investor or adviser has no ability to engage in 1), 2), or 3), then he or she should leave the industry and do something else. This certainly applies to most advisers and investment managers I have met.
But I digress. Back in May 2007, we recognize that there existed unprecedented leverage in the global financial system–and more important, the availability and ability to pile leverage on leverage was drying up. The desire to speculate using immense leverage was not limited to the subprime or LBO markets. Consider that Japanese households were actively engaged in the Yen carry trade, with margin currency trading increasing by 41% to US$896 billion in the Japanese retail market during 1Q 2007 alone. In fact, Japanese individuals were responsible for as much as 30% of all FOREX trading in the Tokyo time zone by early 2007.
Another leverage indicator was U.S. margin debt outstanding. We like to use this age-old, proven benchmark to measure the amount of speculation in the U.S. stock market. While we recognize that both institutions and high net worth individuals can gain access to leverage through futures or OTC swaps, the amount of U.S. margin debt outstanding is much more transparent and is reported monthly. More important, the rate of change in U.S. margin debt outstanding has had significant correlation to other leverage indicators, as well as major peaks and troughs in the U.S. stock market.
For example, in the same May 24, 2007 commentary, we mentioned that the six-month increase in margin debt ($74 billion) had risen to its highest level since March 2000, while the 12-month increase ($77 billion) rose to its highest level since September 2000. We also mentioned that the 12-month increase in margin debt for month-end May 2007 would rise again. In fact, margin debt outstanding rose by $40.2 billion for the month of May 2007 alone. The 12-month increase in margin debt outstanding would eventually surge to a record high of $160 billion by the end of July 2007. At the time, we believed–at the very least–a significant correction was at hand.
Fast forward to today. Many of our stock market indicators are overbought (see our January 10, 2014 commentary “The Message of the CB Capital Global Overbought-Oversold Model“). In our December 22, 2013 commentary (“CB Capital’s 2014 U.S. Stock Market Outlook: Cautious and Moderately Bullish“), we asserted that U.S. stocks in 2014 will return in the single-digits, i.e. 5% to 10%. Furthermore, the latest margin debt numbers (as of December 31, 2013) also suggest of a highly overbought U.S. stock market, as evident in the below chart. In fact, the 12-month increase in margin debt has risen to $123 billion–the highest level since July 2007, and certainly the highest level since the current bull market began in March 2009. Seen in this context, even a single-digit return outlook in U.S. equities in 2014 could be construed as being too optimistic.