For some reason, when some people look at the following chart, they get nervous.
The chart shows the amount of margin credit extended by New York Stock Exchange member firms and the price of the S&P 500 Index. Superficially, it seems like they tend to move together. The fear is that the only factor driving stocks higher is the lending (margin credit) from a broker to his or her clients. This fear is so common that even Esther George, the president of the Federal Reserve Bank of Kansas City, has mentioned it as one of the reasons she has been dissenting from the Federal Open Market Committee (FOMC) policy of expanding its balance sheet. President George has also listed distortions in the high-yield fixed-income and leveraged-loan markets as reasons for her dissent.
If the FOMC decides to slow the pace of expansion of its balance sheet, will these bubbles pop?
I don’t think so.
When it comes to margin credit, many studies—some done by the Federal Reserve itself—have shown that margin credit growth is a consequence of stock price increases, not the cause of stock price increases. When stock prices go up, investors can borrow against those gains. However, there’s a more important point: Not all margin credit goes to buying stocks! Margin credit can be used to buy anything that is marginable, like bonds, commodities, futures, options, and exchange-traded funds. Also, when someone shorts a stock (borrows it and sells it with the hope of buying it back at a lower price), if stock prices move up instead of down, the short-seller may have to post more margin.
That, then, raises President George’s second set of concerns—distortions in the high-yield and leveraged-loan markets. Tom Price, portfolio manager with Wells Capital Management, has an excellent podcast addressing the leveraged-loan market, available at On the Trading DeskSM, which is a must-listen-to interview. Tom points out that there is a lot of diversity in the high-yield and leveraged-loan markets. Much of the activity has been issuers of debt refinancing existing debt at lower rates, which improves the cash flow situation of the issuers. Default rates and yields on other fixed-income instruments are low, so it’s probably reasonable to see high-yield rates being low. There may be distortions in some cases, but it is not systemic or to the point where you could reasonably say the whole market is a mess.
While some people might see bubbles wherever they look, I think there are better explanations for the behavior of the market.