January losses prompt rethink for US equity investors

January 31, 2014 8:11 am

January losses prompt rethink for US equity investors

By Michael Mackenzie in New York

Was the stock market dip just a blip or the start of a correction?

Keep calm and carry on. That’s the message from Wall Street as a rough month for equities draws to a close.

Bears must be wary of drawing too many conclusions from just one month. In spite of the current bone-chilling temperatures and swirling flurries, spring beckons, say the eternal market optimists.

To put the performance of the S&P 500 in context, the full extent of its drop this month merely erased the gains seen during the last two weeks of 2013 – a year that saw the market’s benchmark chalk up a 30 per cent gain.

But, as storm clouds gather over areas of emerging markets and US companies post meagre revenue growthfor the fourth quarter, investors are faced with the question: was January just a small speed bump in the five-year US equity bull run, or the prelude for greater challenges in the form of heightened volatility and bouts of pronounced risk aversion?

Front and centre in all this stands the Federal Reserve, which this week announced a further $10bn tapering of its bond buying and signalled it would continue the steady withdrawal of its liquidity backstop as the economy strengthens.

As the potency of the Fed’s liquidity medicine is steadily reduced, many investors expect a normalisation in thebehaviour of equities, principally an end to the virtually uninterrupted rise in prices since the Fed stepped up its bond buying in September 2012.

Not since the early summer of that year has the S&P 500 experienced a standard correction of at least 10 per cent. This type of pullback, like a gardener pruning roses in late winter in order to encourage healthy growth in the spring, is what many professional investors would like to see this year.

The rationale is that after the market’s big run up last year, a pullback would enable investors to “buy the dip” – the kind of trading strategy that typified the massive rally in US stocks during the 1990s, notably in 1997 and 1998 when emerging markets also flashed code red.

Certainly if forthcoming economic data validates the Fed’s faith in a stronger recovery, the January pullback in the equity market will very likely be a modest affair. The risk to this comforting scenario is that years of easy money has bred complacency – as we are seeing play out among emerging market countries.

Closer to home, underpinning the US equity market’s massive rally in recent years has been the willingness of investors to bet big on the premise that the Fed has their back, in the form of record levels of margin debt. Money borrowed to buy stocks hit $445bn at end of 2013, above the levels that characterised the market’s peaks in 2000 and 2007.

Alhambra Investment Partners this week said not only has margin debt hit a record, there has been a massive rise in overall leverage. “As soon as the calendar flipped from 2012, it was as if investors suddenly lost all caution and embraced as much leveraged risk as could possibly be attained.”

The firm estimates that total margin debt usage last year jumped by an almost incomprehensible $123bn, while cash balances declined by $19bn. “This $142bn leveraged bet on stocks surpasses any 12-month period in history.”

As we all saw during the financial crisis, what really transforms a market tremor into something approaching panic is excessive levels of borrowing or leverage forcing investors to quickly slash their holdings. Buying on the margin cuts both ways in that it can push asset prices sharply higher, while also exacerbating a slide in the market.

Russ Koesterich, chief equity strategist at BlackRock says the high level of margin debt reflects the complacency of many investors coming into the new year and that is always a yellow flag.

And it is waving. The massive inflow of money into exchange traded funds in recent years is set for a rare reversal in January. ETF’s are popular with retail investors and hedge funds, so they are a barometer of fast money flows. Popular baskets that track the S&P 500, Nasdaq and Russell 2000 index of small-cap stocks have recently experienced pronounced outflows.

A torrent of margin calls and larger ETF outflows can easily feed on itself and may well prompt a far stronger corrective slide in stocks than investors expect.