Donna Block
SHARE WORLD
There are days when I really miss the action on Wall Street, the rush that comes with the execution of a great trade and the hustle and bustle of trying to stay ahead of the market. Then, of course, there are the days when the wild volatility that is characteristic of today’s markets makes me say, “Thank goodness I’m out of it.”
The most distressing part of those kinds of days for me used to be when the market closed and the mysterious people you never see in the back office sent out “margin calls”.
Investors who trade on margin borrow from their broker to buy more stock than they have cash to pay for, and hope that a rising market will make the gamble pay off. Maybe it will and then again maybe it won’t, but the bean counters in the back office are recalculating the debt and when the market goes wrong, calling for more money. Moreover, as the stock market gets increasingly volatile, regulators in the United Stats are getting more and more concerned about the amount of margin debt investors have racked up.
As prices have soared, so has the debt accumulated by many investors. Margin debt at New York Stock Exchange member firms grew from $140,1-billion in 1998 to $228,5- billion last year. The Federal Reserve sets margin requirements, and since 1974 the deal has been that investors have had to put up half the initial cost of buying a stock and the brokerage puts up the other half. As long as increases in margin debt kept pace with gains in share prices, few fretted.
Then, last November and December, margin debt rose 25% while stocks rose 11%. Alan Greenspan, the Fed chair, has worried that the rise may be an indicator of froth in the market. But he has also said that he will not raise margin requirements to tone things down, since limits on borrowing could hurt small investors.
Other Wall Street economists disagree and are concerned that there is too much inappropriate use of credit for speculation in the markets which may present risks to the financial system.
Margin is wonderful when it works. But it only really works when shares rise. When share prices drift or fall, margin becomes very costly. Brokers charge an adjustable rate of interest, with higher rates charged on smaller loans, and also compounded on a daily basis, so what an investor winds up paying is always higher than the stated rate.
Margin also takes its toll on the overall market. Heavy investor debt can exacerbate a market’s decline; as share prices fall, investors who have borrowed are more likely to sell their holdings, rather than put up more cash. It’s what some on the Street call “the crack of doom”, the moment when you know you’re not just going to lose money but you’re going to lose a lot of money.
Those investors who are in debt try to get out to cover their shortfall, and those who are not get out because they don’t want to ride the roller coaster down.
Nonetheless, lending money to investors is easy and very lucrative for brokerage firms; they make money on margin interest and the extra commissions that come from investors buying twice the stock they would have otherwise. Neither a borrower nor a lender be – not in this stock market.
Margin debt and the upshot of Greenspan’s speech were not the only worries in markets this week. Besides the “Greenspan effect”, there’s what some pundits call the “January effect”. At the end of every January, theories, strategies and advice about the direction of the stock market for the rest of the year abound. The key concept is something called the “January barometer”, which has many interpretations, the simplest of which goes: “As January goes, so goes the year.”
The theory has an uncanny track record. In four out of five years since 1950 January has foretold Wall Street’s fate for the coming year. January 2000 saw most major markets averages go down. Stocks ended their first losing month since September with a rally on the 31st as fund managers and investors went bargain hunting.
Barron’s magazine, a New York-based financial publication, did a check of January and full-year movements in the Standard & Poor’s Index for 1950 through 1999 which showed that the January barometer was correct 40 times, or 80% of the time.
Disbelievers might argue that it could all be just luck rather than a natural link between the performance of one month and of 12 months. But even those who aren’t completely sold on the indicator see worth in it. One analyst based in New Orleans says the real key is the market’s strength or weakness in the first five trading days, while other analysts completely dismiss the January barometer.
Their contention is that the “old rules” do not apply any more, and so they are going to ignore the January effect.
But many investors don’t appear to pay too much attention to the January barometer. That includes the new breed of momentum traders – those who can’t resist the latest Internet or high-tech stock, day-traders who seem to trade minute by minute, and a whole array of other speculators, as well as investors who select stocks on their fundamentals rather than engage in market timing.
If January is a barometer for the rest of the year, and history repeats itself, buckle up, because we’re in for a wild ride.