Stocks Crashed the Last Two Times This Happened

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“Your largest wealth creator for the top end has been inflation in financial assets,” Charles Peabody, a bank analyst at Portales Partners, told the Wall Street Journal. “You’re now seeing wealth destruction,” he said.

On Wednesday, the S&P 500 soared nearly 4%, its largest percentage gain since 2011, after having spent a whopping two days in a correction, its first since 2011.

On Monday, I’d written, “We’re expecting a rally topped off by a majestic short squeeze in the near future.” And we’re getting that. But the index is still down 5.8% year-to-date, and 3% for the 12-month period. Quite a change from the relentless double-digit uptrend of the past several years.

Margin debt is a big force behind stock prices. It’s the great accelerator, on the way up and on the way down. When investors buy stocks with money they don’t have and that the broker creates for them, it drives up stock prices, and makes room for more margin debt as higher stock prices allow investors to borrow even more against the same number of shares. It’s wonderful.

But when stocks tank, already spooked investors may be forced to sell to pay down their margin debt to stay within the limit. Forced selling drives down prices further, which begets more forced selling. Some of that happened last week, and particularly this Monday when the Dow plunged over 1,000 points at the open.

Margin debt has a nerve-racking habit of running up sharply and then peaking right around the time stocks crash. In the last sixteen years, there have been three majestic spikes, each greater than the prior one.

In March 2000, margin debt hit a record of $278.5 billion, just as stocks had begun to crash. Then a few years later, with memory about crashes being short-lived, margin debt spiked again, peaked at $381.4 billion in July 2007, and fell off. Thus stocks embarked on their epic crash.

Momentum stocks got killed first. As their values dematerialized, brokers sent out margin calls to their frazzled clients, and forced selling set in, and the selloff turned into a rout.

Now margin debt has spiked again.

In June, it hit another record high of $504,975, as reported by the NYSE. It’s the highest ever even if adjusted for inflation (Doug Short runs an excellent series on this) and even as a percent of GDP, at 2.85% compared to 2.60% and 2.73% for the prior two peaks.

This is the classic margin debt. But there are other forms of margin debt, including loans backed by portfolios of stocks, bonds, mutual funds, ETFs, and other securities. The loans can be used not to buy more securities, but to buy man-toys, make a down-payment on a mortgage for a home or an investment property, start a business, blow on a big vacation, or whatever.

This type of loan allows investors to draw money out of the markets without having to sell securities. The Wall Street Journal reported that, “according to lending executives at brokerage firms and analysts,” clients would be allowed to borrow “40% or less of the value of concentrated stock positions or as much as 80% of a bond portfolio.”

It was a good deal for everyone.

Investors loved it because, as asset prices were getting inflated year after year, they could borrow more and more against their very same portfolios, draw the money out, and live the good life. Financial advisors love it because they get paid a fee for their clients’ assets in their account, regardless of the loans drawn against those assets, and this fattened the fees. And banks and brokerages loved it because they scooped easy interest income off the loans, and they marketed them aggressively.

With all entities eager to do these loans, nothing stopped margin balances from ballooning into dangerous proportions. At Morgan Stanley, these types of loans have shot up 37% year over year, to $25.3 billion as of June 30. At BofA Merrill Lynch these loans soared by 14.2% year over year to $38.6 billion. At Wells Fargo’s wealth unit, these loans and classic margin loans combined soared 16% to $59.3 billion.

According to the Journal, “the biggest brokerage firms have all reported higher securities-based loan balances or higher client-loan asset totals, each quarter for more than two years.” These client-loan asset totals include both securities-based loans and the classic margin accounts.

These securities-based loans have become so popular, have been marketed so aggressively, and entail so much risk for clients that the Financial Industry Regulatory Authority (FINRA) has put them, as the Journal put it, on “its so-called watch list for 2015.”

Then the equation fell apart.

Energy stocks and bonds crashed, even those of some large companies like Chesapeake. Some have reached zero. All kinds of other stocks and bonds have gotten eviscerated over the past few months, even tech darlings like Twitter or biotech giant Biogen. Portfolios with a focus on the wrong momentum stocks took a very serious hit.

And margin calls went out. The Journal:

Some lenders, including Bank of America Corp., are issuing margin calls to clients after the global market drubbing of the past week, forcing investors to choose between either putting up more money or selling some of the securities underlying the loans.

Other banks too sent out margin calls, including U.S. Trust, Morgan Stanley, and Wells Fargo, according to the Journal. With margin calls mucking up the scenario, spooked investors are trying to lower their leverage before they’re forced to, and the boom in securities-based lending appears to be over. And the wealth units of the banks that gorged on these loans are likely to see their profits dented.

If that continues, a much crummier thing happens: margin balances reverse. And the last two times they did after a majestic record-breaking spike, the stock market crashed.

But for most Americans, the rosy scenario has already gotten tangled up in reality. Read… Americans’ Economic Outlook Plunges

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  17 comments for “Stocks Crashed the Last Two Times This Happened

  1. robert h siddell jr
    August 27, 2015 at 9:25 am

    My heart bleeds for the chosen people who can borrow millions at low rates to buy stocks.

  2. Mark
    August 27, 2015 at 10:11 am

    Don’t want to be broken record but it happened exactly as I said few days ago.
    Brief correction is over and frenzy buying takes place today and till end of the week.
    I know that reality in life and stock market these days is twisted so better for all of you if you adapt early and divorce doom and gloom.
    Bad days on market will happen again in not to distant future but remember there is only one way for market to go UP, UP and way UP. After all IT IS YOUR MONEY we play with and our PAPER which nobody will give @#$% if it implodes.
    So nice trade you made CASH for PAPER.
    Happy investing. Cheers.

  3. Chris
    August 27, 2015 at 10:18 am

    What goes up must come down. The higher the ascent the greater the fall. What we are witnessing and have been witnessing across broad segments of our economy over the last 20+ years is an unhealthy economy fed by bubbles that inevitable pop. One need only follow the pattern to see that each successive bubble has been larger than the last and, correspondingly, each successive crash has been worse than the last. Simply injecting liquidity into the economy does not solve the fundamental imbalances that have become so evident. Lower domestic production, greater consumption of imported goods and a flood of dollars exported throughout the world. This simply cannot be sustained and it will ultimately end very, very badly. Incurring debt to facilitate growth is a short term patch, not a permanent system. It is ultimately unsustainable. The global economy is on the verge of collapse but our government and the FED (the banks) tell us all is well. That’s probably what they told the passengers in the lower levels of the titanic.

  4. Dan Romig
    August 27, 2015 at 10:38 am

    Adding to this warning is an eye opening article on today’s http://www.wallstreetonparade.com
    regarding stocks like Apple, Amazon, Facebook, Google and Microsoft. Adding these five companies’ market caps equals more than the total market cap of the Frankfurt, Germany stock market!

    Amazon loses money, and still it’s worth over $240 billion. As eager as I am to short it or buy puts, I don’t have the cajones to go against the tides that keep the stock price insanely high. Any opinions on this Wolf?

  5. LG
    August 27, 2015 at 11:01 am

    I really really wonder if the Fed has anything to do with “fabricating” these corrections. Look at Bullard for example. It seems hey can keep going on with this rate hike to no rate hike injecting a couple billions game for ions!

  6. Mike R.
    August 27, 2015 at 11:43 am

    Trust me. All the US markets are heavily manipulated by the Fed. Stock market, bond market, key commodoties such as oil, gold, even food stocks.

    • Sabbie
      August 27, 2015 at 11:49 am

      Not just the Fed, CBs around the world. Swiss for example moves tons of US equities.

    • Vespa P200E
      August 27, 2015 at 12:27 pm

      Indeed but CB may be too reactive and use “precious” monetary ammos too soon to appease their handlers AKA banksters so they can bail out (distribute their holdings) to lemmings and buy the dip-shit muppets.

      Soon the lemmings will learn a harsh lesson on dead cat bounce and bit of strength illusions on the way down, way way down.

  7. Vespa P200E
    August 27, 2015 at 12:34 pm

    This is how the Fed responds to its bankster handlers to boost stock price so they can get out in past 24 hrs:

    1. Trumpet that no interest rate is expected in Sept
    2. U.S. second-quarter GDP revised to show larger 3.7% gain but wait that means Fed should raise rates soon but I digress

    Heck – next up might be leaking info about QE 4 so their handlers can get out with fat gain and lemmings in US (like China) get slaughtered on basty next leg down.

    • Sooze
      August 30, 2015 at 7:59 am

      “Heck – next up might be leaking info about QE 4 so their handlers can get out with fat gain and lemmings in US (like China) get slaughtered on basty next leg down.”

      That already happened on Wednesday, courtesy of Dudley. He said that now may not be the time to raise rates, but no one would be considering QE4 any time soon. Well, that was dog whistling to the muppets: “If things get really bad then we will start up QE4.”

      Dow soared 600 points after that.

  8. Michael Gorback
    August 27, 2015 at 1:26 pm

    What is HY doing if you back out energy bonds? Last time I looked the spread between general HY and energy HY was something like 400 bps.

  9. Julian the Apostate
    August 27, 2015 at 3:05 pm

    “Nothing is not something. Nothing is not so.” -Chuang Tzu

  10. rich black
    August 27, 2015 at 4:19 pm

    If we go back to early 1929, we can see that the margin buying balloon had grown so large, that even the Fed tried to deflate it. However, the big banks trumped the Fed, and the balloon continued to take on hot air. Then there were the “bucket shops”, which might be the early ancestors of today’s unregulated derivatives. The rest, of course, is history—and history rhymes.

    Interestingly enough, the 1929 stock market crash was preceded by the giant Florida land speculation crash, three years earlier.

  11. NotSoSure
    August 27, 2015 at 5:17 pm

    Nah, the big banks will ape China. Perhaps Goldman Sachs Shenzhen (http://www.bloomberg.com/news/articles/2015-08-27/heard-of-china-s-fake-rolexes-now-there-s-a-fake-goldman-sachs) will issue margin debt backed ABS straight to your pension funds.

    It will not be over until EVERY single cent belonging to anyone not belonging to the 1% has been sucked up in various ways.

  12. Mark C.
    August 27, 2015 at 5:26 pm

    I think that with the general poor economy i.e.: a ‘masked depression’
    people seeing China and the stock market are spooked even more.
    expect less spending-and a dismal Xmas

    • NotSoSure
      August 27, 2015 at 9:25 pm

      GDP is revised up by a huge number. The doomers have been repeating this “inventory” mantra for quite a long time now, but Amerikans have stepped up to the plate gobbling everything up.

      • interesting
        August 28, 2015 at 12:15 am

        “The doomers”

        if you lived in my economy you’d be a doomer too, and it’s been this way since about 2002 if not before

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