In this Friday’s shoot-the-shit I share with readers what actually concerns me, and it’s not ISIS.
No doubt you’ve all heard about how well the stock market is doing. The stock market has experienced 15% compounded growth over the last few years. Why?
We’d like to think that it signals an economic recovery, yet we still see wage stagnation, consumer spending is not robust, savings rates are virtually nonexistent; in fact, any gains that we’ve seen in recent months come from lower oil prices and not a strong economic recovery. Lower oil prices we know have a positive and immediate impact on disposable incomes. Yet when oil prices fall we don’t see a market rally; instead, we see a market decline. Don’t they realize that higher disposable incomes are good for the overall economy? Yes they do – and this is a question that I’ll come back to. However, what it suggests to me is that the stock market values sector earnings more than a macro economic boost and there is a reason for that. I don’t need to tell you business owners that increased disposable income is good for the total economy, so what the hell is it with Wall Street?
Wall Street is the catchall name given to the financial sector and although financial services are wide in scope, they have one universal characteristic, they create nothing. They are in the business of renting capital for a fee, return, and/or part ownership, or in any combination thereof. To take your company public, you pay a fee. To acquire capital for day to day operations or expansion, without taking your company public, you can seek and negotiate venture capital, for a fee and/or extending part ownership. You can consign your receivable accounts, again for a fee, or you can borrow money for a fee, which we call interest. Wall Street does one thing and that is allocate capital to where it has the highest return. It’s you, the entrepreneur or business owner, that create product, employment and real economic growth. Some Wall Streeters see themselves as captains of industry and enablers of enterprise, which is complete and utter bullshit that comes from drinking the wrong Kool-Aid. Wall Street rents capital period, and they are very good at it.
Wall Street is also a lender to investors, offering what’s called margin debt. Here is how margin debt works. Let’s say that you want to buy $100 worth of stock but you only have $80 to spend. Using a margin account, you can borrow $20 to make the purchase (note: that margin requirements vary and are regulated). So, you put in $80 cash out of pocket and buy $100 worth of stock by borrowing $20. Obviously you pay interest on the $20 loan, but the market is returning 15%, and because you are a super cool customer you are allowed to borrow the $20 at the prime lending rate, currently 3.25%. So, your net positive spread is 11.75% on the $20 loan. Now, imagine the overall effect on billions of dollars in margin credit. The gains are huge!
For the sake of discussion, let’s say the stock you are buying is trading at $1 per share. If you use out of pocket money, your purchase is limited to 80 shares but with the $20 loan you can now buy 100 shares. This is what you’ll hear described as leverage. So, margin allows you to purchase a greater number of shares, which when done on a large scale across the market creates a demand for stock (also called equity) that would not otherwise exist.
This is what margin debt looks like in March 2015. It is at historical highs. The chart that you see above is current to Feb 2015, and it clearly shows that margin debt is at historical highs. Why is there so much margin debt on the books, particularly in an economy that is only lukewarm; with a global picture where China’s economy is cooling and the EU is in recession? Very simply because institutional investors and corporations are borrowing at historically low rates and plowing huge amounts of money into a stock market that is returning 15%. Not bad hey! I pay 3.25% to borrow and get 15% on the borrowed money. This condition has several OH SHIT components to it.
1. Stock market returns are coming from investor demand for stock and not a strong economic rebound. Investors are buying so much equity and using so much margin debt that market growth is fueling itself. The underlying micro and macroeconomics aren’t providing the price support, it’s investors capitalizing on the spread that’s doing it, and if you can borrow for less than the market returns why not? To sustain this margin debt driven stock rally, now on its 5th year, the market needs to tout corporate earnings, which is the reason lower oil prices are viewed by Wall Street as a negative when in fact they are positive in the broad economy. I want to be cautious here because there are a number of companies that are meeting and exceeding earnings driven by market share and sales. The best example is Apple who increased iPhone sales in China 72 percent. Tim Cook, Apple’s CEO, was quoted as saying “I’ve never seen as many people coming into the middle class as they are in China.” Sadly, he can’t say the same thing about his own country where Americans are falling out of the middle class. The point remains the same and that is that ballooning margin debt is driving market valuation.
2. In 2014, if you were a small business trying to get a bank loan chances are you were declined. In fact, across the 5 major banks, less than 22% of small businesses who applied for loans got them. Banks would rather lend to the financial markets than to small business. This is one component to the equation for low growth in employment. Who is it that creates jobs and drives economic growth? It’s Small Business, yet they continue to be underserved by the financial sector. Small Business owners have two competitors for financing, Wall Street and the U.S. Government, and that accounts for meager business lending.
3. We have a Federal Reserve that finds itself between a rock and a hard place. If they increase interest rates, it will dampen Wall Street borrowing, somewhat, and you’ll see the market correct downward, but that interest rate increase would hit mortgages, consumer credit, business lending, durable goods, on and on. Since higher interest rates add to the everyone’s cost structure, across the board, you would also see prices increases. At this stage of the recovery, higher interest rates from the Fed would have the same effect as dumping a 55 gallon barrel of water on a smoldering campfire. Not Good! Now for the last OH SHIT…
4. Remember, that the house of cards needs to be able to show corporate earnings, to justify its continued rise. This will become increasingly more difficult if oil prices remain low or fall. And, with a slumping global economy, Wall Street will look to companies to improve earnings which managers will achieve by cutting payrolls and further outsourcing of production.
Don’t agree? Take a look at what margin debt has done from 2009 to March 2015 it’s dammed near a vertical line (the red line). So, where has the benefit of low interest rates gone?
Wall Street not Main Street!
Fixing the problem is going to require a couple of thing: first, a set of balls the size of bowling balls; second, a very hard look at regulations to tighten margin credit across the spectrum. I especially feel that trading commodities like oil on margin should be limited to those traders taking delivery of the commodity. On the fiscal side it may also be useful to reinstate differential tax treatment of short term and long term capital gains.
If you’ve draw the erroneous conclusion that I’m anti Wall Street, allow me to reaffirm that I’m not. A profitable, vibrant and healthy financial sector is essential to a strong economy, but boys will be boys, as we saw in the 2008 meltdown, and Wall Street’s profitability should never undermine fundamental economic growth and infrastructure.
So, what do you think about all this?
I hope you’ve enjoyed this week’s shoot-the-shit. Remember that profanity, unsupported opinions and changing subjects will not be censored. And, you’ll never see a bill from me!
Have a great weekend. Get out and do something with your buds and/or family!
FOG HORN 