Tuesday, December 3, 2013 Zeb’s VUE

General Information and Analysis

US

Stock market sets another new record last week.

Now what, I wonder?  Houston, we have a problem.  In October, total margin debt on the NY Stock Exchange climbed to a new all-time record of $412 billion.  For those of you that need to know, margin debt is money borrowed by investors and traders to buy stocks.  This increase in debt almost always occurs at market highs.

The reason this occurs of course are varied as people’s ideas about the market direction.  At this point in time, borrowing money at low interest rates in order to invest money for higher returns seems like a good idea. 

The stock market has a way of humbling those who feel pretty smart and comfortable; as price tends to form important long term tops near or at peaks in margin debt.  When investors have borrowed the most money to leverage their investment in stocks, the price starts to fall. 

In many ways, this is normal auction market theory.  That is when all the buyers have bought, the only direction for price is down.  The opposite also holds true: when all the sellers have sold, the only direction for price is up (except when price collapses, companies may go out of business, leaving nothing to buy).  This is normal supply and demand.  However, margin is leverage.  The higher the leverage, the more panic ensues when even a minor correction takes place.

I created a table that indicates how market tops aligned with peaks in margin debt:

Date	Margin Debt Peak	Stock Market Top
Dec. 1972	$7.9 billion	one month later
Dec. 1980	$14.5 billion	one month before
Sept. 1987	$44 billion	one month before
Feb. 1994	$62 billion	the same month
March 2000	$278 billion	the same month
July 2007	$381 billion	three months later

(I could have gone back into late 1800s and shown the same thing, which leads one to believe that human behavior does not change rapidly if it changes at all. Also notice, the table clearly indicates that margin is not an accurate timing tool, as markets can top before debt margin declines, or markets can reach a top several months later.  What is clear throughout history, that when the stock market reaches new all-time highs on growing margin debt, there will be a major price correction.)

In March 2000 as one data point, the debt on the NYSE rose to $279+ billion, and then debt began to fall.  Later in March, the S&P 500 reached a top just over 1520.  However, over the next 28 months, the index lost 45%.  Ouch…

More recently (which is old history to investors), in July of 2007 margin debt set a new all-time record above $381 billion, and the S&P 500 set a new record above 1560.  Near the end of July, debt started to fall.  Seventeen months later the S&P traded as low as 667.  Again, history is not “nice” to over-leveraged investment in the Stock market.

For those outside the big banks, we do not know for sure whether or not margin debt has peaked in November.  We do know that history repeats; although it does not repeat exactly.  Leverage is hard on people who go into debt.

In the meantime, the US still faces the debt ceiling crises. We are still waiting on Yellen's response to tapering (or not).  China is making war noises, and the US has already tested China's resolve in the South China seas.  

The time to take some profits off the table is now.  If one does not take some profits, then please take out insurance by hedging with options.

US Currencies:

“Inflate or Die”  (Richard Russell)

If one looks at gold (and silver) prices, of course an investor would flee from investing; although if I was a trader the volatility should be lucrative – ha!!.  Japan, US and Europe are all trying to create inflation.  If gold and silver are a store of value, then one cannot help but wonder where inflation is (not what governments report, but where investors think they should store wealth to avoid inflation). 

If we observe the dollar index chart, the dollar over the short term remains bullish.  However, if the dollar index touches the 78 price (currently at 80.94 closing yesterday), that will trigger a sell signal, and humans being what they are will dump dollars. This will upset the whole apple cart. 

What is happening with the multi-trillion dollars of debt that the US owes?  Answer: Debt in terms of dollars remains stable.  The Federal Reserve is still creating dollars out of thin air, and if they continue to create dollars at the current rate, eventually debt will appear manageable.  The trick is to create $$$ faster than medium and long term debt without creating hyperinflation.  “Inflate or Die” (I believe this slogan is from Richard Russel).

Gold continues to get clobbered.  For the investor, forget all the conspiracy theories and why inflation should make gold soar.  For investing, there will be time to get in when gold soars.  In the meantime, gold’s price is going down and down.  For very long term investing, gold is buy and hold using dollar-cost averaging.  Someday, gold will either soar making you very rich indeed, or it will be a way to trade for goods if the country should experience civil war such as happened in Egypt, Libya and Syria in the last 2 years.  In the meantime, price is going down, and why would you buy an asset going down. (Yes there is a theory that states buy when something is so low it can’t go lower, but try timing that.  You will probably find retail investors go broke on that theory.)  However, I am not an advocate of leverage in options or futures markets in order to short gold either.  That is a loser’s game for retail investors.  

Watching this Week:

• Speculation on Fed Taper…

a.   Today’s headline in Reuters… investors worried over the possibility the Fed will taper.  The stock market is down.

• Company earnings will be in focus to support stock market valuations

a.   With the stock market reaching highs (almost every week), will the rally continue?  Citi Bank suggests the market may retreat with an 83% probability of losses over the next 12 months.  That is not particularly new if you watch word from analysts out there. 

b.   Basically, Fed watching has more effect on the stock market, but almost everyone agrees that earnings  need to keep improving.  According to Jeff Kleintop at LPL financials, “…the 17 - 18 PE (is) where every secular and cyclical bull market has ended since WWII (with the exception of the late 1990s that ended much higher) a better pace of growth must materialize; just more bond buying by the Fed is not enough to lift valuations from current levels to propel further gains.”

• European Earnings – bottom line – earnings season “stank, stunk, phew”.  

• What is deflation doing in Japan, US and Europe?

a.   Gold and Silver prices are indicating that deflation is winning. 

b.   Analysts in Europe (specifically Societe General) are warning falling commodity prices are a symptom of a GROWING DEFLATION THREAT.

c.    US Fed tapering would certainly exacerbate those concerns.  Fed tapering risks extend far beyond US interest rates.  Almost certainly US rates will have a domino effect on global bond rates.  The potential consequence:  US bonds would compete with higher yield and counteract ECB and BoJ (Bank of Japan) efforts to keep rates low. 

d.   Emerging markets would be significantly damaged (except China) as their bond prices would fall, as right now investors are drawn to higher yields in emerging markets. Emerging markets usually export commodities, and higher rates hurt assets such as commodities.

e.   German consumers have cut spending 4 out the last 5 months, and retail sales last week were reported down.  Christmas season is not looking good in Germany.  France also fell. 

• Escalation of tensions between China and Japan must be watched.  The US has already tested China’s resolve, and China dispatched military jets to patrol the area under dispute.