The Biggest Threat to Your Portfolio
While the Dow Jones Industrial Average and the S&P 500 hit record highs this week, there are troubling signs that the market's rally is unsustainable. Investors are using leverage to boost returns, and leverage is hitting record highs. Previous bubbles have been shown to be heavily inflated by investors who are buying stocks with margin debt, and this time is no different. What's going on, and what can you do to protect yourself?
What is margin debt?
Margin debt refers to a loan you take from your broker to buy stock. With the Federal Reserve keeping rates at all-time lows, margin debt is cheaper than ever.
The dangers of leverage
Over the years, numerous investors have sounded the alarm over investing with borrowed money. Most famously, Warren Buffett has said:
I've seen more people fail because of liquor and leverage -- leverage being borrowed money. You really don't need leverage in this world much. If you're smart, you're going to make a lot of money without borrowing.
A great example of the perils of investing with margin debt comes from the former third member of Warren Buffett's trio of investors. Rick Guerin decided he wanted to get rich quick and used leverage to boost his returns. In the bear market of 1973-1974, when the market dropped 70%, Guerin got tons of margin calls and was forced to sell his Berkshire Hathaway shares to pay off the loans. The rest is history, as Warren Buffett and Charlie Munger went on to make Berkshire the powerhouse it is today.
A dangerously inflating bubble
While Federal Reserve Chairman Ben Bernanke said just last week that "I don't see much evidence of an equity bubble," I believe the signs of a bubble are growing. At the end of every month, the New York Stock Exchange reports the previous month's value of margin loans investors hold, as well as cash and credit in those accounts. We have to wait till the end of the month for February's numbers, but we can see that in January, margin debt climbed to near the all-time highs set in the previous bubble.
Perhaps more ominous, the difference between credit and margin debt in accounts is expanding to near the all time high of -$213 billion that was hit during the Internet bubble.
The New York Stock Exchange only began collecting data on cash in margin accounts starting in 2003, but you can still see the net value of investors' margin accounts. The free credit line is inverted so that when the red line is up, that means investors are net in debt, and when the red line is way down, that means investors have more credit and cash in their accounts than debt. In January, investors had nearly $77 billion more debt in their accounts than they had investments and cash.
Foolish bottom line
All these charts show that investors are using leverage at levels not seen since the last bubble to juice their returns. This has ended badly in every previous bubble, and it will end badly again.
Trying to time the bursting of a bubble is a fool's errand. It's impossible to get the timing right. I suggest sticking with your investment plan but keeping some cash on the side to buy in case the market takes a big drop. As Thomas Edison said, "Everything comes to him who hustles while he waits." Take time to carefully research investments and keep a watchlist of companies you'd like to buy at the right price.
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The article The Biggest Threat to Your Portfolio originally appeared on Fool.com.Dan Dzombakcan be found on Twitter @DanDzombakor on his Facebook page,DanDzombak. Hehas no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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