Bob Mestjian, one of our advisors and a fellow resident of Melrose, Massachusetts, wrote in with a very good question, to wit: “At the National Conference, you mentioned margin debit balances skyrocketing. However, I'm trying to reconcile skyrocketing margin debt with what I keep hearing about record levels of cash on the sidelines. Is there cash on the sidelines? Are there select investors who want to take risk ‘all in,’ using margin, while others are in cash and want nothing to do with stocks?”
Good question. First, let’s look at the concept of “cash on the sidelines.” This is a commonly used phrase, but unless the cash is actually stuffed in a mattress, it has to be somewhere in the financial system, where its removal—or relocation, really—would have effects. The phrase is usually a misnomer, as it reflects an investor preference for other asset classes over stocks.
There is some wiggle room on this at the moment, however, due to the large amounts of cash floating around the system thanks to our friends at the Federal Reserve. Even so, for retail investors, the notion of “cash on the sidelines” is misleading. For most of them, particularly in tax-deferred investment accounts such as 401(k)s, the cash is not on the sidelines but in bond funds of one sort or another.
In theory, then, reallocation from bonds to stocks by retail investors on a mass scale would drive interest rates up, with a negative effect on stock prices. This is not happening, due to Fed intervention and bond buying, even as retail investors do start to reallocate. But the idea shows how “money on the sidelines” isn’t actually just clean new buying power, as it will have other effects. The other component of the market is institutional investors, and here the notion of money on the sidelines is simply wrong, with most managers fully invested, according to most reports.
To bring this back to Bob’s question, there are two separate things going on here. One is the use of leverage by investors in the market, for a variety of reasons, and the other is the investment level of both retail and institutional investors. At our recent National Conference, I mentioned that margin debt was high by historical levels, which has nothing to do with how much equity investors have in the market. In fact, the margin debt is the disconnect between the two. You can have more equity and even more debt at the same time.
Here’s a housing example. For a town like Melrose, where Bob and I live, suppose everyone put down $20,000 on their house as a down payment, but that, as prices rose from $100,000 to $200,000 per house, they kept putting down that same $20,000. You would see the effective equity increasing in aggregate, even as it remained the same for each individual house; at the same time, the aggregate mortgage debt would rise. The comparison isn’t exact, of course, but this is one way to think of it. As prices rise, more borrowers are borrowing more to buy, even as the amount of equity remains the same or increases.
The answer, therefore, is that debt levels can rise even as investors commit more equity to the market—but that fuels an even larger increase in stock prices. It is just the fact that debt capital is more easily called away than equity capital that makes higher prices, supported by debt, more risky, which was the point I was trying to make.