The West has been living with cheap money from the central banks for over 5 years. Credit has been very easy to obtain in the financial sector, and interest rates have been at all-time lows. The result can be seen in the chart above from Business Insider of total lending to fund stock purchases on the New York Stock Exchange (margin debt)
- US margin debt has been at all-time record highs this year, higher even than in 2000 and 2007 (red line)
- Rises and falls in the amount of this margin debt are 96% correlated with movements in the S&P 500 (blue)
China’s ‘collateral trade’ has also been a major part of the ‘unseen hand’ of easy credit that has propelled world financial markets to record highs since the financial Crisis began. The risk now, as China starts to unwind this trade, is that ‘what went up together, also goes down together’.
We last saw this effect in September 2008. The cause is simply explained by the work of Hyman Minsky:
- His insight was that a long period of stability eventually leads to major instability
- This is because investors forget that higher reward equals higher risk
- Instead, they believe that a new paradigm has developed
- They therefore take on high levels of debt, in order to finance ever more speculative investments
This, course, is exactly what is happening today. Investors believe that the US Federal Reserve will never let stock prices fall. And at the same time they are being given zero-cost money by the Fed with which to speculate, due to the Fed’s belief that higher stock prices will increase consumer confidence and restore economic growth.
At some point, however, as in 2008, another ‘Minsky moment’ will occur:
- Earnings from the new investments will prove too low to pay the interest due on the debt
- Confidence in the ‘new paradigm’ will disappear and, with it, market liquidity
- Investors will find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid
- In turn, this will prompt a rush for the exits. Prices will drop quite sharply, as ‘distress sales’ start to take place
The chart also highlights one even more worrying development. The amount of margin needed to boost the real value of the S&P 500 to its peaks (adjusting for inflation), has risen from $280bn in 2000 to $440bn in 2007, and to $465bn today. Yet in real terms, the S&P 500 is still below its 2000 peak. As Nobel Prize winner Robert Shiller’s data shows, the S&P 500 reached 2057 in 2000 when adjusted for inflation - versus 1763 in 2007 and its recent peak of 1900.
This highlights the fundamental instability of today’s stock market peak. The blog fears that the second Minsky Moment may not be far away. Then investors will find out for a third, and perhaps final time, that even the Fed cannot print enough money to maintain the speculative bubble forever.
Exchange Traded Funds (ETFs) will likely be the instrument of destruction this time, rather than subprime loans to the housing market, or over-valued dot-com shares. As US investment magazine Barrons has warned:
“ETFs will be the delivery mechanism. There was just $531bn in ETFs at the end of 2008, so the now-$1.7tn industry has been largely untested in a major selling panic, replete with disappearing liquidity and credit system seize-ups. We suspect that these funds could exacerbate the selloff that may be impending. Our best advice: Be vigilant, don’t get carried away, and look out below.”