The Downside of Leverage

Jeez, can everyone just calm down a bit?

A headline in today’s Financial Review asks whether we’re in for a replay of the 1987 meltdown! That comes after spiking global yields and a two day stock market sell-off on Wall Street.

Overnight, the Dow fell 300 points, or 1.15%, putting it on track for the biggest two-day fall since August last year. You may remember that infamous month saw a particularly vicious fall of…2.61%…

So, what’s with the 1987 comparisons?

The Financial Review ‘explains’:

This year, the US sharemarket has notched up its best start to the year since 1987, when the S&P 500 clocked up a spectacular 13.2 per cent gain in the first month of the year.

And, perhaps coincidentally, Steven Mnuchin has become the first US Treasury Secretary to explicitly talk down the US dollar since … well, since 1987 when James Baker (who served under under then US President Ronald Reagan) threatened an aggressive devaluation of the US dollar against the Deutsche Mark and the Japanese yen unless West Germany and Japan adopted more expansionary economic policies.

Baker’s threat is often seen as one of the triggers for the October 1987 market crash. Investors started selling bonds on fears that a sharply lower US dollar would reignite inflation and trigger a collapse in the bond market as foreign investors shied away from buying US financial assets.

Long-term US interest rates climbed sharply higher through 1987, eventually bringing an abrupt halt to the sharemarket’s rally.’

What the article doesn’t point out is the absolute insane rally that preceded the 1987 crash. Check it out…

Insane rally that preceded the 1987 crash. Dow Jones Industrial Average 31-01-2018

Source: Optuma
[Click to enlarge]

From the September 1985 low, the Dow soared 112% over the next two years. That compares with a two year gain today (from the January 2016 lows) of just over 70%.

That’s big. And history suggests you’ll see a decent pullback to correct those gains. There might even be a mini-crash. But comparisons with 1987 seem overdone.

And anyway, the Aussie market has been a major laggard in this latest market rally. From the 2016 lows, the ASX 200 has only rallied 30%.

Therefore, you should expect to see the Aussie market fall much less than US stocks in any pullback.

The message is to not be surprised about a correction. It’s completely normal. Just don’t be freaked out by comparisons to 1987, or even 2008 for that matter. The situation is completely different.

Yesterday I discussed some possible reasons behind weakness in the US dollar. I made the comment that US dollar weakness is actually bullish for global stocks and US dollar strength is generally (but not always) bearish for stocks.

Think of it like this… 

When the US economy is strong and generating large current account deficits, it usually means healthy credit expansion and a flow of US dollars to the rest of the world.

These US dollars flow to countries generating trade surpluses. Without central bank intervention, the inflow of dollars pushes up the value of the local currency relative to the dollar.

Many trade surplus countries don’t like their currency appreciating relative to the US dollar. It makes their goods less competitive. So their central banks intervene by buying US dollars with newly printed currency.

This newly printed currency then flows through the domestic economy, creating bullish conditions for economic growth and asset prices.

In other words, a weak US dollar is bullish for the world!

The risk is that that all this printing of money leads to inflation. I think that’s what the bond market is reacting to now.

But again, let’s put things into perspective. The yield on 10-year US Treasury bonds is just over 2.70%. In early 2014 it was 3% and in early 2010 it touched 4%.

True, debt levels are much higher these days. That means the global economy is much more sensitive to rate rises.  That is, the global economy is more highly geared that it’s ever been. What does this mean?

Think about gearing at a personal level. When you have a highly geared share portfolio for example, it’s usually very volatile. The ‘equity’ value swings around considerably while the value of debt remains fixed.

If you apply this rationale to the global economy, then you should expect the equity value of the global economy’s assets to swing around too. This equity value is represented by the world’s stock markets.

However, over the past two years there has been no volatility at all. The highly leveraged global economy has been good for global stocks.

That’s highly unusual. Perhaps now it’s time to experience the downside of this leverage?

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia