Chart of the day: Margin debt security dealers and brokers vs SP 500
We dislike commenting on the stock market as we are no experts. However, the chart below has caught our attention. It depicts the relationship between the amount of margin debt and the level of the SP 500. It is indeed a very high correlation. The margin debt data is found in the Flow of Funds statistics compiled by the Federal Reserve every quarter, thus it is not as timely as the daily performance of the SP 500.
The chart below is an indication of two scenarios and both are not positive for the stock market:
1) If margin debt has shot up in the fourth quarter and kept on increasing in the first quarter, this means that stock market investors are now borrowing money from security dealers and brokers and are paying a hefty bill of interest to keep buying the stock market. The 2.5% dividend yield they receive is not enough to cover their interest expense. What these investors are doing is simply borrowing money at a rate of 6% and above and are hoping that prices will continue to go up to cover the cost of their debt. This looks like a Ponzi Scheme to me.
2) If margin debt is not increasing and this divergence persists or even gets worse, it simply means that the stock market is rising on the back of very few purchases and this can be evidenced by the performance of the 7 mega stocks compared to the performance of the rest of the market. If this is the case, my question is then what does it mean for the price of a stock like Amazon, if its P/E ratio is a whopping 59 times and no dividends are paid? Animal spirits.
Animal spirits can persist for a long time till something major breaks. What would be this major thing:
1) Full regional war in the Middle East that would double the price of energy.
2) Deadlock in the US Presidential elections where no candidate can secure the 270 majority votes of the Electoral College.
3) Inflation surprises on the upside and forces the Federal Reserve to refrain from cutting rates and maybe start raising them again.
Every single scenario of the three above has now a significant probability of taking place.
Again, I am no expert on the stock market but I would love to have your commentary. That's because a crash in the stock market is in our opinion the biggest risk to the US economy.