One by one, the excesses of pandemic-era financial markets are unravelling.
From cryptocurrencies, to meme stocks, to work-from-home beneficiaries, to unprofitable tech companies, the themes that defined the past two-plus years in investing are in swift retreat, in many cases already having returned to prepandemic levels.
The risky strategies adopted by the investing masses when everything was rising are also being undone. Margin debt and options trading, for example, which helped juice returns on the way up, are now accelerating losses on the way down.
“It’s a doom cycle of sellers pushing prices lower, which then encourages more selling,” said Jason Mann, chief investment officer at Toronto-based EdgeHill Partners. “That’s why you can get wild swings up and down, seemingly without logic.”
The pandemic saw the buildup of a vast amount of leverage in financial markets. Margin debt, which allows investors to borrow against their holdings in order to boost their stock market bets, spiked by more than 70 per cent from before the pandemic up to last October, according to U.S. data.
A call option is another way of leveraging returns. It involves betting on a stock rising above a specific price within a particular time period, and the payoff can be upward of 10 times higher than simply buying the underlying security.
While options are typically a tool for large, sophisticated investors, the rise of discount brokerages with free trading gave regular investors unprecedented access to more complex instruments. By early 2021, call option trading attributable to individual investors rose from about 2 per cent of the total volume on the New York Stock Exchange, to a record high of nearly 10 per cent.
It ended badly. A research paper released last month pegged the losses to small investors trading options at US$1.1-billion between November, 2019, and June, 2021 – a period of time encompassing the meme-stock craze.
The great deleveraging of 2022
Margin debt to nominal U.S. GDP
4.0%
3.5
3.0
2.5
2.0
1.5
1.0
0.5
Jan.
1995
June
2000
Nov.
2005
March
2010
Feb.
2022
Aug.
2015
the globe and mail, Source: Stifel
Nicolaus Canada
The great deleveraging of 2022
Margin debt to nominal U.S. GDP
4.0%
3.5
3.0
2.5
2.0
1.5
1.0
0.5
Jan.
1995
June
2000
Nov.
2005
March
2010
Feb.
2022
Aug.
2015
the globe and mail, Source: Stifel Nicolaus Canada
The great deleveraging of 2022
Margin debt to nominal U.S. GDP
4.0%
3.5
3.0
2.5
2.0
1.5
1.0
0.5
Jan.
1995
June
2000
Nov.
2005
March
2010
Feb.
2022
Aug.
2015
the globe and mail, Source: Stifel Nicolaus Canada
Retail options trading activity has since shrunk back to prepandemic levels.
Margin debt is also on the decline, but at more than 3 per cent of U.S. GDP, remains well above troughs coinciding with bear markets in recent years.
“While we would like to be more constructive on certain areas of equity markets, the simple fact is that we are currently experiencing a deleveraging of the system,” James Hodgins, an analyst at Stifel Nicolaus Canada, wrote in a research note this week.
In previous such episodes surrounding the bursting of the dot-com bubble and the global financial crisis, that figure bottomed out at around 1.5 per cent.
“One would expect central banks to intervene before we get to that level,” Mr. Hodgins said. But, “given current levels of inflation, one must ask the question however, what if they don’t?”
The fight against rising consumer prices means central bankers likely have less room to support financial markets as they have in recent years.
The impact of runaway inflation on investor sentiment might also help explain some of the recent market action.
At times, the selling has been indiscriminate, consuming all segments and sectors of the market, including those typically thought of as safe havens. Defensive stocks, high-quality bonds and gold have all taken their lumps in recent weeks.
Even the energy sector, by far the best performer on the Toronto Stock Exchange this year, hasn’t been spared in recent days. On Thursday, oil and gas stocks within the S&P/TSX Composite Index lost 1.3 per cent, even as crude oil prices moved up on the day. Many other companies posting positive earnings surprises are seeing their share price decline anyway.
Those patterns suggest many investors want out of the market entirely.
“They’re not looking for alternative investments right now. Their source of safety is cash,” said Kevin Headland, co-chief investment strategist at Manulife Investment Management.
“There is the idea that liquidity is being sucked out of the market, that the punchbowl is being taken away.”
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