I’ve been working in the investment industry for 28 years now. Throughout that time, I have yet to find the “secret” to investment success – the one thing you can do to guarantee outstanding performance. I don’t know anyone else who has either. It is a combination of many important factors.
However, I have found the secret of what I might call “unsuccess” – the one reason, more than any other, why some investors (including some very wealthy, very smart investors) don’t do as well as they should; the one thing you can do to guarantee underperformance.
And that is: overconfidence.
Overconfidence in your investment thesis – that an opportunity will play out exactly as you think it will. Overconfidence in your predictions – the belief that you have the right “read” on the market, or the economy, or a given financial event. Overconfidence in your particular point of view – that you don’t have to revisit or reconsider your strategy, or hedge or diversify your portfolio because you’ve considered every possible contingency.
Over the years, I have seen more financial disasters – both personal and “macro” – caused by overconfidence than by any other reason. Looking back, we can see that overconfidence in U.S. residential real estate is the reason we went through the 2007-08 U.S. financial crisis. Back in 2001, overconfidence in the New Economy (dot-coms and other high-tech stocks) caused the Nasdaq Stock Market bubble to burst. And I’m pretty sure that whatever crisis we face next, the root cause of it will be overconfidence.
That’s why I like to keep a very close eye on measurements of market confidence. The idea is simple: The more confidence there is, the greater the possibility that investors are being overconfident, and the more likely there will be some form of correction or pullback in the near future.
There are many different statistics and surveys and formulas that track confidence. But the one I like most is the level of margin debt. It’s a little different than other measures in that the figures are already several weeks old when they’re published. But it’s a reasonable leading indicator when considering the next 12 to 36 months.
What I like is that margin debt isn’t subjective – it doesn’t rely on what investors say about confidence, but rather what they do. Borrowing to invest is the ultimate expression of confidence: The only reason you do it is because you think the market is going up.
Over the past 20 years, margin debt has had a strong positive correlation with stock market returns. When margin debt gets high, chances are that a contraction is around the corner.
So, what is margin debt telling us right now? Well, margin debt as a percentage of gross domestic product recently peaked at about 2.8 per cent of U.S. GDP. Over the past 20 years, this figure has crossed over the 2.5 per cent threshold two times. In both cases, the U.S. market dropped 45 per cent to 50 per cent soon after.
Take a look at the accompanying chart, which tracks the growth of margin debt on the New York Stock Exchange against the compounded growth of the S&P 500 (reflected by SPDR’s S&P 500 ETF).
Two things immediately jump out to me
Margin debt is high by historical measures
Extremely high. Yes, things have backed off since topping out earlier this year, but such a high level of margin debt still poses a significant danger if interest rates were to rise, or if any economic data come along to suggest the Fed may be forced to raise rates more quickly than expected.
We’ve seen this before
The pattern that’s developing seems ominously similar to 2000 and 2007-08. In each case, margin debt reached a new high, and then declined right before a significant downturn. You can see this most clearly prior to the two recessions, but also in a number of “mini-dips” (in 2010, and the end of 2011).
Now, as any veteran investor knows, the past is never a perfect predictor of the future. Even so, the similarity in the pattern suggests to me that it’s time to take profits and reduce margin (and other debt). This is probably not the time for high-risk/high-return situations – better to rein in speculative positions and approach new opportunities with a hefty dose of caution. This is what the smart money has been doing for some time.
Don’t get me wrong: There are still opportunities out there. But you need to be very selective about them. They are contrarian in nature, with deep value, out-of-favour assets that require discipline and patience, and a careful “what if” analysis.
Always remember: Margin or leverage is like jet fuel. It amplifies the thrust of the market direction, either up or down. After 6 1/2 strong years, the data are suggesting that it’s time that investors pull the throttle back.
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