It’s déjà vu all over again


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Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending.

Small investors are borrowing against their portfolios at a rapid clip, reaching levels of debt not seen since the financial crisis. …The fear is that as more investors rely on money borrowed against stocks, any significant fall in stock prices will be magnified if investors are forced to sell securities to raise cash and meet margin requirements.”It’s the irrational move of the leveraging up that helps [drive] the boom, when the air comes out of the bubble, the situation gets exacerbated on the way down.”

Golly gee, do you think these two things could be related in any way? All financial crises are preceded by leveraged credit bubbles. The gamblers need Other Peoples’ Money (in this case, the taxpayers) in order to bet. The Casino rolls on.

Articles from today’s WSJ:

The Federal Reserve’s Policy Dead End

Quantitative easing hasn’t led to faster growth. A better recovery depends on the White House and Congress.

 By MARTIN FELDSTEIN

The Federal Reserve recently announced that it will increase or decrease the size of its monthly bond-buying program in response to changing economic conditions. This amounts to a policy of fine-tuning its quantitative-easing program, a puzzling strategy since the evidence suggests that the program has done little to raise economic growth while saddling the Fed with an enormous balance sheet.

Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

But despite the Fed’s current purchases of $85 billion a month and an accumulation of more than $2 trillion of long-term assets, the economy is limping along with per capita gross domestic product rising at less than 1% a year. Although it is impossible to know what would happen without the central bank’s asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed’s actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve’s Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Earnings per share of the Standard & Poor’s 500 stocks rose 50% in 2010 and a further 9% in 2011, driving the increase in share prices. The S&P price-earnings ratio actually fell to 17 at the start of 2013 from 21 at the start of 2010, showing the importance of increased earnings rather than an increased demand for equities.

In short, it isn’t at all clear that the Fed’s long-term asset purchases have raised equity values as the portfolio balance theory predicted. Even if it did account for the entire rise in equity values, the increase in household equity wealth would have only a relatively small effect on consumer spending and GDP growth.

There is one further puzzle about the quantitative-easing program. The Fed’s purchase of Treasury bonds and other long-term securities has not been nearly as large as the increase in the government debt during the same period. The Fed’s balance sheet has grown by less than $2.5 trillion since the summer of 2007, while the federal debt has grown by more than twice that amount just since the beginning of 2009. As a result, the public has had to absorb more than $2 trillion of net government debt during the past three years. At best, the Fed’s long-term asset purchases reduced the extent to which the federal deficits crowded out equity purchases.

The Federal Reserve has rationalized its use of long-term asset purchases and its explicit guidance about future values of short-term interest rates by noting that conventional monetary policy—lowering the federal-funds rate—is not possible now that the fed-funds rate is very close to zero. With a dual mandate that includes growth as well as price stability, the Federal Open Market Committee apparently feels a compulsion to do something. Unfortunately, the evidence suggests that it hasn’t worked.

Mr. Bernanke has emphasized that the use of unconventional monetary policy requires a cost-benefit analysis that compares the gains that quantitative easing can achieve with the risks of asset-price bubbles, future inflation, and the other potential effects of a rapidly growing Fed balance sheet. I think the risks are now clear and the benefits are doubtful. The time has come for the Fed to recognize that it cannot stimulate growth and that a stronger recovery must depend on fiscal actions and tax reform by the White House and Congress.

Investors Rediscovering Margin Debt

 By ALEXANDRA SCAGGS and STEVEN RUSSOLILLO

Small investors are borrowing against their portfolios at a rapid clip, reaching levels of debt not seen since the financial crisis.

The trend—driven by a combination of rising stock values and rock-bottom interest rates—is sparking a growing debate among market watchers.

To some, this trend in so-called margin debt is a sign of investors’ increasing confidence in a bull market for stocks that has already lifted the Dow Jones Industrial Average 15.1% in 2013.

But to others it is a warning sign that the Federal Reserve’s easy-money policies are creating a bubble mentality among stock investors.

As of the end of March, the most recent data available, investors had $379.5 billion of margin debt at New York Stock Exchange member firms, according to the Big Board.

That is just shy of the record $381.4 billion in margin debt set in July 2007.

In March, the level of margin debt stood 28% higher than one year earlier, a time frame that saw the Standard & Poor’s 500-stock index rise 11.4%.

The fear is that as more investors rely on money borrowed against stocks, any significant fall in stock prices will be magnified if investors are forced to sell securities to raise cash and meet margin requirements.

“Borrowing is cheap,” said Randy Frederick, managing director of active trading and derivatives at Charles Schwab Corp.

“The big danger in trading on margin isn’t that the market goes down a little, it’s that the market goes down a lot,” said Mr. Frederick. “It could cause a downturn to accelerate.”

With margin debt, investors pledge securities—stocks or bonds—to obtain loans from their brokerage firm. The money desn’t have to be used to just buy more investments. The funds can be used in what ever way the account holder wishes.

Interest rates can vary significantly for account holders. A valued client may pay less than 1% interest on the loan, while others could pay more than the prime rate, which is now 3.25%.

Jamie Cox, managing partner at Harris Financial Group, a financial-services firm in Richmond, Va., that manages money primarily for retirees, said a client this week used margin debt to finance a $70,000 home-improvement project that included renovating a kitchen, bathroom and a couple of bedrooms.

In this case, margin debt was viewed as a more attractive option to pay for the project than was selling stocks in the portfolio to raise cash, Mr. Cox said.

One reason is that the interest on margin debt is tax-deductible, he said.

Mr. Cox, after consulting with his client, could then selectively sell some securities and let dividend payments pay down the margin loan. “He decided it was a great alternative,” Mr. Cox said.

For some market watchers, rising levels of margin debt are a sign that investors are becoming complacent and making decisions based on the idea that stocks can only go up.

“You have to feel really good about the market to be borrowing to buy more shares at these levels,” said Bruce McCain, chief investment strategist at Cleveland’s Key Private Bank, a subsidiary of KeyCorp . “It’s probably a sign of excessively positive sentiment right now.”

As evidence that the high levels of margin debt are a warning sign, some analysts note that margin debt hit a peak at the onset of the last two bear markets.

Margin debt topped out in March 2000, which turned out to be the top of the dot.com-stock bubble.

The July 2007 margin-debt record preceded the stock market’s subsequent peak in October of that year.

Others are less worried. “This is not a warning that the markets are becoming frothy,” said Jim McDonald, chief investment strategist at Northern Trust, whose firm manages more than $700 billion. “It makes sense in this environment to lever up and to take advantage of stronger returns.”

To some degree, margin debt reflects the movement of the stock market itself, some note. The more that stocks are worth, the more that investors can borrow.

“Coincidence doesn’t imply cause and effect,” said Schwab’s Mr. Frederick. “The fact that two things move together doesn’t mean that one is causing the other.”

In addition, some note that when the level of margin debt is compared to the value of the stock market, it isn’t as close to a record high as the absolute levels of debt.

The total amount of NYSE margin debt as of the end of March was 2.7% of the market capitalization of the Standard & Poor’s 500-stock index.

At its precrisis peak, investors had borrowed as much as 2.9% of the S&P 500, and at its crisis low, investors were borrowing 2.3% of the S&P 500’s market value.

Still, many say that higher levels of margin debt could ultimately magnify any stock-market selloffs, even if they are not on the near-term horizon.

“It’s the irrational move of the leveraging up that helps [drive] the boom,” said Cullen Roche, founder of San Diego-based Orcam Financial Group, a research and consulting firm. Because unwinding that debt could lead to forced selling, “when the air comes out of the bubble, the situation gets exacerbated on the way down.”

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