Condos in Toronto on May 19, 2021.Christopher Katsarov/The Globe and Mail
Ultra-low interest rates and a powerful rally in asset values have encouraged Canadians to pile on record amounts of debt to invest in stocks, bonds and other financial instruments. And concerns are escalating that it’s not going to end well.
Monthly client margin debt – money lent by brokers to buy or short a stock – hit an all-time high of $31.8-billion in February, the latest available figures, according to the Investment Industry Regulatory Organization of Canada. In the United States, margin debt monitored by the Financial Industry Regulatory Authority reached US$861.6-billion in May, also a record.
The pandemic has accelerated what was an already voracious appetite for using leverage. Borrowing in brokers’ margin accounts has more than tripled in Canada over the secular bull market in place since 2009, and now stands well above the peaks reached prior to the stock market meltdowns of 2008 and 2000. In the U.S., margin debt has similarly risen above its previous highs.
The trend is raising alarm among long-time market-watchers.
“I am concerned about the growing leverage,” Mohamed El-Erian, Allianz SE chief economic adviser and president of Queens’ College, University of Cambridge, said in an e-mail interview. “It is part of a more general phenomenon of excessive and, in some cases, irresponsible risk-taking enabled by a prolonged period of ultra-loose financial conditions.”
In the same camp is Michael Burry, founder of Scion Asset Management (and famous for his huge bet against U.S. subprime mortgages in 2007, as portrayed in the movie The Big Short). “Speculative stock bubbles ultimately see the gamblers take on too much debt. The market is dancing on a knife’s edge,” he tweeted in February.
Margin debt statistics actually understate indebtedness because many investors alternatively borrow through home equity lines of credit (HELOCs) and mortgage refinancing.
In 2020, the amount investors borrowed against their home equity came in at $18.1-billion, representing 24 per cent of all home equity borrowed, according to surveys conducted by Mortgage Professionals Canada.
While down from 2018 levels, the amount homeowners borrowed to invest was a jump of 58.8 per cent from 2019 and a near doubling of the amount in 2016 (the year data first became available).
With mortgage rates at rock-bottom levels, HELOCs and mortgage refinancing seem destined to become even larger sources of investing leverage. Moreover, recent sharp gains in house prices have dramatically boosted homeowners’ equity, providing another powerful engine for expanding investment loans.
Using debt to magnify investment gains works well when markets are on a one-way path to new record highs, and the strategy has paid off well for many investors over the past year. But using leverage also will mean much more painful losses in any serious market downturn. And some believe the high leverage levels are an indicator of excessive bullish market sentiment that often foreshadows a significant correction in equities.
“I think this will be very ugly,” said John De Goey, portfolio manager with Wellington-Altus Private Wealth Inc.
Mr. De Goey is firmly in the bear camp, believing valuations – particularly in the U.S. stock market – have become way too frothy to be sustained. “I would be borderline shocked if we didn’t have a major pullback by the end of the year,” he said in an interview.
He notes that the S&P 500 Shiller CAPE ratio, also known as the cyclically adjusted price-to-earnings ratio – which takes the current price of the benchmark U.S. index and divides it by the 10-year moving average of inflation-adjusted earnings – is trading at a historically high level of 37. That’s up from 33 at the start of this year and, according to Mr. De Goey, implies future returns will be virtually non-existent over the next decade in U.S. stocks.
“I don’t think anyone – virtually no one that I speak to – is thinking and acting in terms that are that stark. They simply whistle past the graveyard on the pretense that ‘I’m bulletproof because the Fed’s got my back, or the Bank of Canada,’” with their ultra-loose monetary policy, Mr. De Goey said.
For his few clients that have margin accounts, he has sold all investments that he perceives to be susceptible to a market pullback. If he does recommend using margin, it wouldn’t be until a pullback in equities of at least 20 per cent. “But I think what we’re looking at down the road is going to be a lot more than that,” perhaps a drop in the value of U.S. stocks of about one-third, he says. “I really think the market is ridiculously expensive.”
Robb Engen, a fee-only planner who founded the Boomer & Echo personal finance blog, said he has seen a lot more interest this year from his clients and readers for using leveraged investing. This includes using strategies such as the Smith Manoeuvre, which involves homeowners making principal payments against a mortgage and then borrowing the same amount on a line of credit used to buy investments. This makes the interest tax-deductible.
The non-deductible house mortgage progressively gets paid down while the loan increases and, with luck, investment values grow faster than outstanding debt.
“It reminds me of 2006-07 when the Smith Manoeuvre was getting a lot of uptake. Investors see strong market returns plus low interest rates and feel like they can dial up their risk with a leveraged loan,” Mr. Engen said. “Of course, the financial crisis put an end to that idea.
“Now a new batch of investors are looking at leveraged investing as a way to juice their already strong recent returns. I don’t think it’s a good idea. I’d ask anyone who is seriously considering a leveraged investment loan how they felt in March, 2020, when their non-leveraged investments were down 34 per cent and it looked like we were in for a prolonged bear market,” he said.
Buying stocks on margin magnifies gains and losses. Consider a case where an investor buys $20,000 worth of stock on a 50-per-cent margin, thus putting up only $10,000 of his or her money (the broker lends the rest). The next day, if the price of the stock drops 20 per cent, it would leave $16,000 in the margin account. Net of the broker’s loan, just $6,000 of that amount belongs to the investor.
The investor would receive a margin call to add $2,000 because the 50-per-cent margin requirement on $16,000 is $8,000. If the investor doesn’t add the $2,000, the broker would sell the stock, leaving $6,000 in the account (after the broker takes back his $10,000 loan). The end result would be a capital loss of 40 per cent on the investor’s initial $10,000 investment.
David Chilton, author of The Wealthy Barber Returns, has never been a fan of leveraged investing. “The biggest problem with borrowing to invest is the psychological pressure,” he said in an e-mail. “It often causes sleepless nights, panicked exits or both. This is not a theoretical argument – I’ve seen it many times.... Figuring out how much volatility we can stomach ahead of actually experiencing that volatility is an inexact process. For most of us, it’s less than we think.”
Margin debt numbers compiled by regulators also understate the borrowing risk in capital markets overall because of the family offices set up to invest the assets of ultra-wealthy families. These offices don’t manage money for outside investors, and as such, they are subject to less regulatory oversight and have been known to engage in operations such as borrowing billions of dollars at risky, razor-thin margin rates (which don’t require the investor to put up much money and are thus more subject to margin calls). This is what Archegos Capital Management did – until it got a margin call in March to ante up more funds.
When the payment was not forthcoming, Archegos’ phalanx of brokers scrambled to recover their loans by dumping the margined stocks. The avalanche of selling caused prices to plunge, inflicting multibillion-dollar losses on the brokers who were slow to unload their inventories. Their huge losses could have potentially become the trigger for a financial crisis and market crash. Fortunately, the brokers were able to absorb the hit, so the result was just a tremor and not an earthquake.
Until the next bear market arrives, the party is likely to go on, seeing even more retail investors hoping to strike it rich by taking gambles amplified with margin debt, home-equity loans and other forms of leverage such as stock options.
Someone who has already pulled this off is Bruce Burnworth, a do-it-yourself investor and engineer close to retirement. Through a combination of margin investing and long-term call options on Tesla Inc. stock, he turned US$23,000 into nearly US$2-million during 2020, as reported in The Wall Street Journal.
Investors with financial advisers have also done well with a more sober approach attuned to their risk-assessment profile. Amit Goel, a portfolio manager at Hillsdale Investment Management in Toronto, recounts the story of a client whose $5-million portfolio had declined to $3.5-million during the plunge of March, 2020.
“Since he was 10 years away from retirement and owned a paid-off $2.5-million house, we recommended during the sell-off that he dip into his HELOC to increase equity exposure by $500,000,” Mr. Goel said in an interview. “We told him it could take a few years to recover but the market rallied right away and in less than a year he was at $7-million. Now that markets are optimistic, we are telling clients to pull back on leverage.”
York University professor Moshe Milevsky has been leveraged since 2007. He felt that the bond-like nature of his job tenure and pension allowed for a 250-per-cent weighting to stocks. But when he informed his wife of his plan, the response was: “Are you out of your mind?” So, he settled on 150 per cent, but just in time for the 2008 market crash.
“The downturns were obviously difficult to endure,” he told The Globe and Mail recently. “Don’t look! Don’t look!,” he would tell himself, referring to his brokerage statements. His equity exposure is still greater than 100 per cent but has been trimmed back during the bull market because, as outlined in his book, Are You a Stock or a Bond?, leverage should be wound down as one ages since “human capital [or a person’s earnings capacity] declines over time.”
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