No Load Fund/ETF Investing: What’s Driving This Market?

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As I mentioned in my weekly updates, there always seem to be a variety of ever changing factors that have driven this market to its current highs. One, we have not touched on, is the increasing debt big and small investors are using to leverage their investments.

The WSJ reported that margin debt, jumped 11% to $353 billion at NYSE in May, up from nearly $318 billion in April.

For obvious reasons, I’m personally not in favor of using leverage to increase returns. However, this risky technique has enabled many large players (hedge funds) to leverage their buying power by not just acquiring more stocks but also swallowing up entire companies. This is simply an indication that rampant speculation is alive and well.

To make it easier to borrow money and reduce the chances of a margin call, the NYSE launched a pilot program with eight brokerage firms that allows them to assess the portfolio as a whole. So, if one part of the portfolio goes down but the other part goes up, the investor won’t necessarily get a margin call.

Under the financial industry’s old rules, investors who wanted both to buy shares in a company and use so-called options contracts on that stock, to guard against an unexpected drop in the value of those shares, would have to put up separate collateral for both the stock and the option. If the shares dropped in value, the customer might get a margin call, or request for additional collateral from a broker, to cover the price of the shares, even if the value of the option had increased.

With any type of leverage, a normal market correction can easily turn into disaster if many investors have to cover margin calls, which will accelerate selling and worsen the downside effect. The longer this goes on, the worse the eventual outcome.

That’s why you continuously hear me harping on the importance of following a sell stop discipline. When the market trend reverses, leverage will be a killer, while at the same time the exit doors will get very crowded.

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