Here’s What the “Crash Meter” Says About Stocks
Leverage is an amazing thing.
In the physical world, a simple wedge can provide massive mechanical advantage, giving a single worker with hand tools the ability to split solid stone in half or permanently bend metal.
In the financial world, leverage can be an equally powerful tool.
It’s routinely used to magnify profit opportunities that would otherwise be too small on their own. But leverage can go seriously wrong too.
There’s been a lot of attention on leverage this week after Bill Hwang’s Archegos Capital Management blew up in one of the biggest margin calls of all time.
Hwang’s firm was using leverage to make bigger bets on the stock market.
The basic idea is that if your portfolio is worth $1 and you have an opportunity to make 5% returns, you can use 5x leverage and invest $5 to net 25% returns on your capital.
The problem is when the trade moves against you.
When you’re unlevered, you can’t lose more than 100% of your investment. But with the 5x leverage example I used a moment ago, a 20% drop in your trade means you’re totally wiped out.
But even if you don’t personally use leverage, it affects you.
Typically, there’s safety in diversification. When things get shaky, you want to own assets that have nothing to do with one another. The old saying goes “There’s always a bull market somewhere.”
Except that’s not true in market panics when leverage is involved.
Even investments with absolutely nothing in common can behave the same way — because the same people own them. And if those people happen to be getting hit with margin calls, or calls demanding more capital to make up for loses — they start to sell their investments. And it can send everything moving in the same direction. Down.
That’s why during the COVID-19 crash last year, everything seemed to go down at the same time.
During crisis environments, as they say, “Correlations go to one.”
That’s why looking at correlations across different groups of investments is one of my favorite “crash meters” for the stock market.
Here’s what those correlations look like today:
See that big spike in 2020? It’s from the COVID-19 crash that sent everything tumbling together.
Right now, correlations are around 0.5 across the S&P 500. That means about half of the movements of any particular stock right now can be explained by the movements in other S&P components.
That’s not an unusual level. If we were seeing correlations scraping up against the highs from last year, I’d be very concerned about the possibility that more deleveraging on Wall Street (forced or voluntary) could derail the bull market that continues to be in force in 2021.
For now, we’re not seeing that — and that tells me that the Archegos blowup is contained.
But it’s an important thing to keep an eye on as stocks keep on climbing and Wall Street gets complacent, willing to take on risks that they wouldn’t have a year ago.
Meanwhile, the broad market uptrend is still investors’ friend in 2021.
Jonas Elmerraji, CMT