(Bloomberg) What might be the largest margin call in history is ringing fresh alarm bells on Wall Street among those worried about hidden leverage and its potential to fry the financial system.
The forced selling of more than $20 billion of apparently swap-linked shares at Bill Hwang’s Archegos Capital Management has set off a hunt for other areas of excess -- from margin debt to options and bloated balance sheets -- after stocks at the center of the fiasco plunged and investment banks warned of losses.
As with most things in markets, opinions vary: Hwang’s travails are portrayed as everything from phase one of a long-overdue market comeuppance, to an isolated case of risk-taking run amok. While Wall Street may have sidestepped a systemic cataclysm, the blowup is an example of “leverage gone wrong” with ominous portents, said Sameer Samana, Wells Fargo Investment Institute’s senior global market strategist.
“What it does make me think of is how much leverage in aggregate has now built up in the system” in brokerage accounts, options and credit, Samana said. “If a broader stock market pullback were to take shape, especially in the more widely owned areas of technology and technology-related stocks, a much bigger unwind would have to take place.”
On Monday, at least, the S&P 500 Index was barely registering the weekend’s tribulations, its 57% rally since March 2020 intact.
Margin Debt
In recent weeks, as stocks vaulted to new highs, investors have pointed to a worrying trend at brokerages: ballooning margin debt, which at $813 billion at the end February stood at historically high levels (the numbers are reported on a delay). What’s sometimes lost in the discussion is that such debt almost always rises with the value of equities.
“It would be common sense for one to look at this and say, we have a normal amount of margin debt in the system right now for where the market is,” said Arthur Hogan, chief market strategist at National Securities Corp. “I don’t know that that would have been a clear signal as to what’s going on in some of these media stocks and send a warning signal, because you would suspect that in a rising market the margin debt is going to be higher.”
But not every lens into the phenomenon is reassuring, according to Jason Goepfert, president of Sundial Capital Research. Assuming that it will exceed $831 billion when this month’s numbers are reported in April, margin debt will have grown more than 70% year-over-year, one of the sharpest expansions since 1931. That means the year-over-year change in debt will have exceeded the year-over-year change in the S&P 500 by more than 20 percentage points for three months running.
“This kind of excessive and persistent growth in debt, on both an absolute and relative level, has been a boogeyman for forward returns,” Goepfert wrote in a recent note to clients. “The most effective use of the data, both on the upside and downside, has been the rate of change, including relative to the S&P. And that’s why it’s becoming to be a much larger concern.”
Options Frenzy
Speculative mania in the options market has also fueled bubble warnings for the better part of a year. Call contracts -- in which bulls pay a fraction of a stock’s price to bet it will rise -- became the playthings of newly minted day traders, whose enthusiasm for short-dated options is theorized to have fueled a series of bullish feedback loops, particularly in tech stocks.
“As you’re in a bull market with a lot of liquidity, you start to get some areas of overconfidence and some investors let their guard down,” said Keith Lerner, chief market strategist at Truist Advisory Services. “It does suggest a level of overconfidence.”
However, that call volume has eroded from February’s peaks suggests some of the craze for the products is diminishing. Over the past 20 days, an average of over 23.6 million calls have traded on U.S. exchanges. While still historically high, that’s down from nearly 29 million in late February.
Credit Risk Written Off
Companies that have loaded up on debt have been rewarded mightily in the equity market. Stocks in a basket defined by their high leverage have gained over 17% year-to-date, ranking them as the best-performers this year among 17 quantitative styles tracked by Bloomberg. On the other side of the trade, profitability is one of the worst-performing factors, with those shares nursing losses of over 5%.
Goldman Sachs Group Inc. data tells a similar story: S&P 500 firms with weak balance sheets are on track to beat out those with sturdier finances by over 17 percentage points this quarter -- the biggest margin of outperformance since at least 2006.
Taken together, such statistics can be used to paint a picture of a market so frothy that investors are willing to disregard any qualms over credit risk. But it’s also true that those companies -- among the hardest hit by the coronavirus -- stand to benefit the most from the so-called reopening trade as vaccines are given and economic activity picks up. Along with the combined might of governmental fiscal aid and the Federal Reserve’s seemingly endless bond-buying, the stock market’s weakest links can have the biggest bounce.
“These were the companies where investors were most concerned about not surviving, so they tend to get a relief rally,” said Truist’s Lerner. “Having the Fed with so much monetary stimulus and support makes investors more confident this won’t become systemic.”
High Hedge Fund Leverage
It’s not just Hwang’s Archegos that loaded up on borrowed money to make trades. Average leverage across the 10 largest hedge funds clocked in at 15.9 as of June 2020, according to data from the Treasury Department’s Office of Financial Research. While that figure is down from a peak of 24.6 in June 2019, it’s far above the 5 average for the next 40 largest funds.
That number dwarfs the amount of leverage Hwang was operating with. Market participants estimate that the family office’s total assets had grown to anywhere between $5 billion to $10 billion, while total positions may have topped $50 billion.
But while the biggest hedge funds may have more leverage than Archegos outright, it’s important to consider what those funds are leveraged to, according to Bespoke Investment Group’s George Pearkes. For example, concentrating a smaller amount of leverage to handful of stocks is much riskier than putting a bigger amount of borrowed money in instruments like Treasuries or currencies, he said.
“If an asset is less volatile, more leverage can be applied safely,” said Pearkes, a global macro strategist at the firm. “And that’s generally what’s going on with larger funds.”
