I still remember when my mom stopped buying margarine and started buying butter. It was a glorious day, something one cannot easily forget. We had transitioned to margarine some years earlier because – the health “experts” told us – margarine is better for your heart. As it turns out, however, there were other experts that said the exact opposite. So my mom went back to the good stuff. Regardless of where you land on this most-important issue, the benefits and drawbacks of margarine is not the focus of this blog post. Rather, I wish to discuss the benefits and drawbacks of margin, with an emphasis on the much more dangerous drawbacks. As my mama always said (or should have, anyway) “use butter, not margin”.
Margin Debt
Below is a graph that overlays the S&P 500 over the past 20+ years with the amount of net investor credit. Simply put, “net investor credit” is a gauge of how much investors have borrowed to buy stocks, minus any cash available. Today, investors are in debt nearly -$250 billion, leveraging themselves to the gills. Here is the nifty chart created by Doug Short at Advisor Perspectives. The blue line represents the S&P 500 and the red represents the amount of net debt by investors:
It doesn’t take much analysis to see a correlation here between margin debt and stock prices. Back in 2007, as well as in 2000, when the market was setting all-time records, so also was margin debt. And yet, the dollar amount of margin debt during the peaks of the of those two bubbles pales in comparison to today’s levels.
Of interest is the beginning of contraction in margin debt last year in late 2015 through ’16, as the market began to falter. What happened late last year to revive both the bull market and investor’s appetites for margin debt? The election of Donald Trump, which brought with it the anticipation of tax reform, regulatory reform, and the repealing of Obamacare – all of which have not taken place.
The question is how long investors can continue to have such an appetite for investing with margin debt at these obscene prices? And what will happen to their enthusiasm in the event Trump’s reforms don’t pan out? Every investor who has significant US stock market exposure should be considering the implications of these questions. And since virtually everyone does, you had ‘butter’ ask your advisor – and fast. When margin debt contracts, it does so quickly.
Margin Profits
The other type of “margin” to watch out for is profit margin – a key measure of profitability. Profit margin is simply the net profit of a company as a percentage of their revenue. So if your company earned $100 last year, and your profit after all expenses was $5, then your profit margin was 5%. Historically, companies have had profit margins hovering around 5.4%.
Over the past 10 years, however, profit margins have been considerably higher – about 7.2%. This is due to depressed wages, among other factors. While 7.2% may not sound a lot different than 5.4%, it is 33% higher than normal. Why does this matter? Because stock prices are based primarily on earnings; or rather, projected earnings. And projected earnings assume stable profit margins which at present are well above average. Some analysts argue that higher profit margins are sustainable – but this would call into question the very nature of capitalism. That is, it would require that consumers never go searching for, or demanding, lower prices. But we know they always do. So I, for one, protest: profit margins must come down. And when they do, we should expect to see declining earnings and therefore prices.
Most analysts I read today consider US stocks “reasonably” valued to slightly over-valued. However, when we factor a necessary adjustment to profit margins, as well as earnings data for the last ten years (and not just the next few months, as many do), we see a different picture. The CAPE Adjusted P/E ratio, as this is called, is currently over 40. For context, a fairly valued stock market would have a P/E around 16. In other words, stocks are trading at price levels only seen once before: the top of the Dot Com Bubble.
Marginal-ized
Here at Plan Financial, we have been discussing the over-valued US stock market for some time now. And in that time, the market has continued to creep higher. Some might take that as evidence that we are wrong. They might be tempted to take our analysis and place it in the round filing cabinet. They might choose to ignore the warnings on margin provided here, and instead marginalize us.
Be that as it may, we often remind our clients and those who follow us of our primary value as financial advisors. We do not follow the crowd, as many are apt to do. Rather, we seek to provide consistent and predictable returns for our clients over meaningful periods of time. And we do that by buying under-valued securities before they rise and selling over-valued securities before they drop. This is a revolutionary new process called: buy low, and sell high.
And until the prices for US stocks become “low” again, we’ll leave the margin alone and stick to our bread and butter.
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