For a number of real estate speculators, financial leverage is a path to riches. Why buy one property with $500,000 when you can buy five properties with $100,000 down on each? After all, the $2,000,000 in mortgage obligations are little more than a nuisance, particularly when the inflation-adjusted cost of borrowing is free. And the five homes should be worth $600,000 a piece in four years. Heck, the “shrewd” financier would double his/her initial $500,000 to $1,000,000!
Naturally, leverage does not always work out so well. Plenty of folks learned this fact the hard way in the real estate collapse (2007-2011). In the example above, where the speculator had been leveraged 5-to-1, homes that began at $500,000 and fell to $300,000 severe consequences came to pass. The initial $500,000 did not simply fall to $0; rather, it left the individual with negative equity ($500,000) and $2,000,000 in outstanding obligations. That’s what it means to be “underwater.”
The world of stocks is, in actuality, quite similar. Many market-based investors set up margin accounts to buy their favorite stocks with less than the full amount necessary. For instance, let’s say that you believe Facebook Inc (FB) is unassailable, unbeatable and the best thing since skinny lattes. You want 1000 shares of FB, but at roughly $120 per share, the $60,000 you’ve got to your name won’t cut it.
So you decide to acquire the shares on margin, meaning that you borrow an additional $60,000 from your custodial firm and place your existing FB shares up as collateral. Your loan? This initial amount is what the investment world dubs “margin debt.”
If Facebook goes from $120 to $180 as you’ve projected, the 50% price jump would net you a gain of 100% on your investment. You only put down $60,000 and borrowed the other half, but the 2-to-1 leverage would give you $60,000 in gains, or 100% pop.
On the other hand, what if FB actually nose-dived 25% to $90. (I know, I know. That’s impossible. It may even be sacrilegious to imagine.) Just for kicks, though, let’s say that FB did shed $30 per share and hit a maintenance requirement of 25% ($30,000 or $30 per share). You would receive a “margin call” such that you’d be required to come up with cash or liquidate existing shares of FB to deposit the $30,000 into the margin account.
Forced liquidation of your golden egg? That would leave you with roughly 667 shares of FB worth about $60,000, of which only $30,000 is yours alone. That’s right. The 25% decline at 2-to-1 leverage resulted in a 50% loss.
It is conceivable, one may suppose, that Facebook would never suffer a normal bear market decline of 25%. Indeed, the 50% haircut back in 2012 may have been a fluke for the social media giant. Then again, if a 50% retreat were in the cards, a player in the margin debt game would see the entirety of his/her principal evaporate.
Like most people, I have plenty of good things to say about the social media mega-star. I suppose I have some qualms about a price-to-sales (TTM) premium that is 10x greater than the S&P 500 at large — 17.3 versus 1.8 — and where virtually all of the revenue comes from advertising alone.
Nevertheless, what troubles me more about buying into the Facebook story in 2016 is the universal belief that the shares are untouchable and that the price can only go higher. (Read “Wall Street Thinks Facebook Is Perfect.”)
Didn’t we see hear the same stories about Apple Inc. (AAPL)? Didn’t we hear some of the same talk about the New Economy in 2000?
The universal belief system on FB that currently exists will be played out in margin debt. In particular, the correlation between NYSE margin debt and the movement of the NASDAQ index is exceptionally tight. Margin debt up, NASDAQ up. Margin debt down, NASDAQ down. That has been the pattern.
Why is this vexing? For one thing, year-to-date, the Fidelity NASDAQ Composite ETF (ONEQ) is significantly underperforming the S&P 500 SPDR Trust (SPY). That might suggest an investment community that is more wary than ever about momentum stocks in the social media, biotech or dot-com space. More critically, the most adored stocks are the ones with the most margin debt attached to them. While that helps them rise rapidly in bull markets, it causes them to unravel even faster in bearish downtrends.
In other words, margin calls that might someday force the liquidation of beloved FB shares would punish those shares mercilessly, irrespective of fundamental value, balance sheet strength, growth prospects, year-over-year mobile ad revenue or “Zuck’s charm.”
In essence, margin debt may tell you more about what’s in store for Facebook in the next few years than any other factor. If margin debt is trending higher in a sustainable fashion, I would expect FB to outperform the competition. However, if margin debt trends lower and continues lower, I would expect the “untouchable” company’s shares to suffer a worse fate than the broader S&P 500 SPDR Trust.
To be frank, neither the benchmark-tracking ETF for the S&P 500 nor shares of the largest social network would do well if margin debt began tanking. Take a look at the chart below. NYSE margin debt peaked before the 2000-2002 dot-com disaster as well as the 2007-2009 financial collapse. Margin debt is currently showing similar deterioration since its pinnacle in April of 2015. Not surprisingly, both the Dow Jones Industrial Average and the S&P 500 Index hit their respective peaks in May of 2015, and have yet to reclaim those record highs.
Keep in mind, outside of the 2011 euro-zone crisis, when the S&P 500 descended 19% from top-to-bottom (closing prices), margin debt has been on a steady upward trajectory. As of March 2016, margin debt is roughly 10% below its April record. Either margin debt begins recovering the way that it did after the euro-zone crisis, providing a much-needed tailwind for stock assets, or the pattern witnessed in the previous bear markets is likely to destroy a great deal of wealth. And that includes the market capitalization of Facebook.
There’s another way to view the challenges ahead: margin debt-to-GDP. Since 1996 (20-plus years), margin debt as a percentage of the economy has been highly correlated with 3-year forward returns for U.S. stocks. In particular, when margin debt has ascended to 2.6%-2.8% of GDP, forward three-year returns were negative and abysmal; when margin debt descended to 1.2% of GDP — in both 2002 and 2009 — forward three-year returns were positive and outstanding.
Here’s the simple take-home: Facebook is not immune to the adverse effects of financial speculation. If financial speculation via margin debt as a percentage of overall economic activity continues to contract from the record high set in April of 2015, stocks will suffer.
If speculators step their game back up? Well, then, I guess there’s no telling how much higher Facebook will soar.
You can listen to the ETF Expert Radio Show “LIVE”, via podcast or on your iPod. You can follow me on Twitter @ETFexpert. Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.