Stock Market Analysis: Current Margin Debt & Price To Sales Ratio Point To A Correction

Margin Debt to DJIA

I have come to the realization that I am probably the worst stock investor in the world. Second worst if you count my Dad, but he doesn’t trade anymore so I am proud to say I have taken his place. Maybe it is that I just come from a long line of bad gamblers or maybe it is that we analyze things too logically. Whatever the reason, I have been fighting this bull market tooth and nail, only to be stuck on the sidelines watching the numbers continue to rise while shaking my head wondering how and why the market is still going up. It just doesn’t make any sense.

Because of this, I have been “fighting the fed” and watching my portfolio bounce around plus or minus a couple points here and there. Last summer, I actually posted about changing my investments to pick up PG and CHD – both of which would have been fantastic moves had I pulled the trigger. Instead, I sat on the sidelines missing out on the plus 20% I could have made. It isn’t all bad news- I did make one good move by putting some money into a couple REIT’s (AGNC and NLY) because of their huge dividends, but I still didn’t maximize my profits by going all in because I was just too gun shy about this market.

And now, I am absolutely certain, 100% positive, sure as the night is dark, that I am too late to the party. I think the market today is a rickety old house sitting directly over a fault line edged up against a cliff hanging over the Bermuda triangle. I believe the QE whatever number we are on now has propped this whole thing up to an insane level that is begging for a correction. What scares me the most though, is just how fast it could possibly unravel in today’s highly computerized (automated) trading environment.

I think there is a serious recipe for disaster in the making with the combination of high frequency trading, the “quants”, high performance computing systems built specifically to increase the number of transactions, and the final ingredient being the aggregate margin debt in the market. This last part in particular is the most concerning to me. We are back at historically high levels of margin debt which is basically the indicator for a market that has been artificially propped up by funny money. Doing some research, I put a graph together above showing the last two bubbles we went through comparing the DJIA to aggregate margin debt. This correlation is not just an anomaly from the past decade – historically, when margin debt gets too high, a steep decline in the market follows.

Here is one more indicator that I think is worth looking at. Not as glaring as the aggregate margin debt, but interesting none the less. While most people probably talk about PE ratios, I think that is not as telling as the PS ratio – price to sales. The fact is, it is fairly easy to manipulate how earnings are calculated. It is pretty hard to fudge sales though. So here is a look at the last 13 years PS ratio for the S&P 500.

Price to Sales Ratio

Obviously, the 2000 numbers were due to people betting big on the internet even though companies were not really selling much – I would say this represents a ceiling. The following flat years around the 1.4 range could appear to be the “normal” range. Then the dramatic drop in 2008 due to the banking crisis and subsequent fallout creates what probably would be considered a floor. So here we are in 2013 with a steep incline that is quickly putting us back over the 1.4 range.

What I would argue though is that 1.4 isn’t really “normal”. Those 1.4 years were propped up by an artificial housing market where money was being “created” from supposed equity and that money was finding its way into the stock market. Thus, the rapid burst and decline. So I would propose that the real normal number is in the 1.2 range. Taking this into consideration along with the aggregate margin debt, there is reason to be concerned.

Here is how I see it getting real ugly, real fast. Something is going to trigger the first domino, be it an earthquake, tsunami, nuclear reactor, North Korea, or whatever act of God or war. Or maybe it will be something as benign as a series of a couple bad economic indicators (i.e. jobs numbers or earnings reports). Whatever the reason is for the first domino, it doesn’t really matter – the result will be a fast paced decline in stock prices with a never before seen volume of trading. This extreme volume will clog the pipes much like what happened when Facebook went public causing supersized volatility and delayed transactions. That day will be a DJIA minus 700 points kind of day.

The next day will be the margin call day – which will cause the forced selling of underwater securities for some unfortunate folks which will saturate the market with excess equities which will depress prices which will trigger more automated high frequency trading which will…. You get the point.

I think there is even more risk now than in prior corrections though because this market is not really based on anything. You have to really ask yourself, “What is this market made of?”  At least the 2000 market was built on irrational speculation in all things internet related. 2008 had housing. What does 2013 really offer?

Yes, there are smartphones and social media, but there  is nothing of real substance. There is no new great invention that has created this boon. No influx of a population increase to create additional demand. No life-saving or life-improving event. Employment rates aren’t great. And while profits are at a record high (think PE ratio), sales (think PS ratio) are stagnant at best. That just means that companies are running lean – not buying property, plant or equipment nor hiring or giving out raises.

What 2013 does have is plenty of funny money. At some point though, there has to be some kind of reckoning and a correction will be made.  Judging by these charts and historical trends, I would say that time is coming pretty soon.


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