This Indicator Tells Us We Are On The Hedge Of The Next Recession
How to weather the storm in the best possible way
90% of investors are like a flock of sheep. If you are reading this, you probably have some concern about where your money is invested, and you are in that 10%. However, you must know what is going on with the stock market.
The problem with investors being like sheep is that they tend to go off the rails when they don’t have a dog to guide them. If they go off the rails and there is a cliff, they all fall off in a row. So far, the watchdog has been the central banks. They have made investing fun. Everyone can make lots of money, even double or triple, in a few years.
For this, brokers have a feature called margin portfolio. This margin portfolio generally allows you to invest up to 25% of your assets, leaving the rest as collateral. This makes people invest all their money and even money they don’t have.
Some brokers allow up to 50%. This means doubling your investment. But this is a double-edged sword because if you have a portfolio of 100k, you can invest up to 200k. But the moment your portfolio drops 20% (this means having latent losses of 40k), the maximum you can invest is 120k.
Margin accounts work like a Ponzi scheme. This process causes positions to be liquidated right after a decline, selling at a much lower price. When the last player can no longer leverage, the system falters.
The metric that best measures what we are talking about is Margin Debt. This ratio has reached all-time highs, like everything else lately. But investors are using it precisely backward from how they should be using it.
In the example above, the margin index was at minimums in 2001 and 2009. Imagine that in those years, we would have invested with margin, and at the moment that the margin would have exceeded maximums, we would have withdrawn that margin to move our portfolio entirely to cash.
Case 1: Investor invests on margin when most investors do (1999 and 2006). The rest of the time, he is 100% invested in the S&P 500.
In this case, we would have 100k, which would have become 140k.
Case 2: We invested on margin in 2001 and 2009, and when the debt margin reached a peak, we left all our capital in cash.
In this case, we would have transformed 100k into +$5M.
I think the difference is more than considerable.
If you also have a portfolio that benefits from these fall in the extremes, as ours does, and allows you to make returns of +300% at specific moments, you can multiply case 2.
In any case, the combination of rising margin debt and falling stock prices increases the risk to the market and makes the declines much steeper.
This increases the market risk even more, and at this time, it can be costly to make extra money in the markets.