The One Thing That Could Derail the Bull Market

Is your neighbor’s brokerage account the next Archegos?

Last week, we talked a bit about the leverage that brought about the explosive unwind of Bill Hwang’s Archegos Capital, a $10 billion family office that had made leveraged bets on stocks and sent those same stocks into free fall when Wall Street banks forced a margin call on it.

As I told you at the time, the Archegos blowup was well contained – it didn’t create a contagion.

But there’s a closely related risk that’s currently looming.

It may be the only thing that could derail the current bull market…

I’m talking about the growing leverage we’re seeing employed by other market participants, including retail investors.

Have a look at the latest data from financial regulator Finra:

Source: Wall Street Journal

Margin debt has surged more than 49% in the last year, the fastest one-year increase since 2007 and overshadowed only by the dot-com bubble in 1999, per the Wall Street Journal. Simply put, investors are borrowing lots of cash to put it in the stock market.

I want to make one thing very clear: Using leverage isn’t necessarily a bad thing. There are some strategies where leverage makes a lot of sense and can be used with relatively low risk – plain-old vanilla stock speculating isn’t one of them.

But that’s likely where a lot of that margin debt expansion has come from.

Brokerage firms like Robinhood make investing on margin incredibly easy.

Margin is attractive because you can multiply your potential gains if things work in your favor.

But the trouble happens when a trade moves against you. A firm using 5X leverage loses 100% of their own money if their portfolio loses just 20%. On the way down, brokers anxious about clients not being able to repay margin loans can force liquidation, driving prices down further.

This is why, in bear markets, everything seems to go down at the same time.

To protect investors, the Fed puts limits on how much investors can borrow. Generally, it’s 2X. In other words, if you have $5,000 in a brokerage account, you can borrow another $5,000 and put it in the market. While that’s far less leverage than Wall Street firms like Archegos often achieve by using complex derivatives, the effects are the same – regular folks have a lot less to lose.

And that’s why a leverage shakeout looks like the one thing that could derail the current bull.

The good news is that there aren’t any major cracks showing in the foundation yet. The market took the Archegos implosion in stride, which is a good sign. But it was a warning.

We’ll be watching margin debt closely as market upside continues this year. Borrowing needs to slow rapidly for the current trend to be sustainable.

Sincerely,

Jonas Elmerraji, CMT

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Jonas Elmerraji

Jonas Elmerraji, CMT, is Seven Figure Publishing's in house quantitative analyst. He is also a contributor to Technology Profits Daily. Jonas has been with Agora Financial/Seven Figure Publishing since 2009. In 2017, his proprietary trading strategy beat the markets by over 20%.

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