Before the Crash: Buying Stocks With Debt
I saw a very disturbing analysis piece by Reuters news agency today, explaining how investors are borrowing money (because interest rates are very low right now) to buy stocks. This is happening not just in the U.S., but all over the world.
The article, “Stock bull rages globally fed by margin debt“, goes on to explain that this kind of debt (called ‘margin’ debt) has reached a new all-time high, $285.6 billion in January. This surpasses the previous high of margin debt, $278.5 billion in March 2000.
Does that date ring a bell with anyone? It should. It is the month that the NASDAQ reached its all-time high, 5048, before plummeting to lose nearly 80% of its value, landing at 1114 on October 9, 2002. I know many people who lost pretty much their entire investments in that bear market. Maybe you were one of them.
Alan Greenspan and others have written at length on “irrational exuberance,” essentially a psychological attitude that loses sight of risks and places unwarranted bets on the market. I think with the new record high of borrowing money to buy stocks, we are entering a period of irrational exuberance again.
I think there are some differences between today’s situation and that of March 2000. For instance, I don’t think stocks in any one sector are particularly overvalued, as technology and telecom stocks were then. But I do think we’ve had such a long bull run in the stock markets (4 1/2 years now) that some people have once again started to believe the stock market only goes up, and never goes down. Wrong, wrong, wrong.
The scary news is, we are in one of the longest periods in U.S. history (47 months) without a 10% correction in the stock markets. And meanwhile people are ringing up record debts to pay for stock purchases, creating a very dangerous combination.
I am not saying the stock markets will crash tomorrow. I am not saying they will crash this year (although that’s entirely possible). What I am saying is that I think borrowing money to buy stocks is very stupid, particularly when we have gone this long without a major downturn.
And when that downturn eventually happens, all those who borrowed money to buy stocks will suddenly have lost a lot of money on stocks, but they will still have to repay their original debts. Those ‘margin’ borrowers will be forced to sell their stock holdings rather quickly, at whatever price. This glut of stocks for sale will drive prices down further, resulting in more sell-offs to pay off more debts, etc. The resulting correction could drive all the world’s stock markets down 10%, 20%, even 50% (as I mentioned above, the NASDAQ fell nearly 80%).
What does this mean for us? If you are currently an investor, please make sure you are well-diversified and that you are in it for the long haul … what goes down will (eventually) come up, so when the market does go down, you can buy cheaply. But you sure won’t want to sell! So if you will need to pull your investment money out in the next few years, I am worried for you.
If you are not in the stock markets yet, but are planning to start soon, I suggest you don’t put any big sums in all at once, because you may find you put a lot of money in at the top of the market, and then you will watch miserably as it slides for the next few years. A better idea is to invest small sums gradually over time, as prices fluctuate. This ‘dollar-cost averaging’ protects you from making a single big mistake, and if the market does start to slide, you will be buying at cheaper and cheaper prices.
It’s exciting times in the markets when debt hits all time highs. I think we’re in for more drama than we ever got in Queer As Folk. Stay tuned.