“The Margin Clerk”


As we head into another year it is difficult not to take note of the difference a year can make.  Or even a day for that matter. For example the Mini Dow futures posted an all-time high on December 31st, a grand finale of sorts.  The YTD high came the following trading day.  Does that mean that 2014 is bound to be a yearlong hangover caused from a year of what seemed like risk free equity gains?  We’d say most likely not if history repeats itself.

We will wager in fact that 2014 will be a volatile, bumpy ride higher.  Most likely beginning when the market realizes these emerging market issues will not sink the headway the US Federal Reserve fought long and hard for.  But why?

To answer that we need to analyze what will be different in 2014 vs 2013, particularly with respect to price and demand.  Prices are certainly higher which should temper some of the speculative buying demand.  However, this would ignore a popular catchphrase used on The Street, “pent up demand.”  Higher prices often beget higher prices through the conduit of pent up demand.  From those two standpoints we’d be inclined to argue for a smooth year higher.

However there is another angle to consider, the end of the Federal Reserve’s asset purchasing program.  To truly understand its impact it’s necessary to understand how the Fed influences pricing and demand.

When faced with massive global deleveraging the Fed not only lowered interest rates dramatically, but they snatched up assets with open arms.  By purchasing these assets, the Fed served as a proxy for demand that simply was not there.   After supplying trillions of dollars in pseudo demand, coinciding with decidedly lower unemployment, the Fed has finally begun to reduce the asset purchases.  Of course they’ve taken a baby step committing to only ten billion dollars of reduction with the caveat that they may at any time increase purchases again.

Our view is that the demand side will actually stay relatively stable with fed demand being replaced with pent up demand.  This of course is barring any unforeseen macroeconomic shocks, which of course the fed has reminded us they will guard against anyhow.  So what about Pricing?

On paper everything seems to be priced way too high.  We wouldn’t disagree if pricing was left to its own devices, but it’s not.  One part of pricing in a leveraged world is affordability.  The Fed has essentially been the used car salesman of overvalued assets.  A strange analogy I know, but consider a standard line used by car dealers;

“What kind of payment are you looking for?”

Since the majority of buyers will be taking out a loan on the vehicle, they use this line to take the pricing aspect out and replace it with month to month affordability.  A lot of variables go into the month to month payment and they want to adjust those while keeping the HIGH PRICE the same.  I say the Fed is using this same tactic by guaranteeing low rates for what will be the better part of 10 years before they even consider raising them.  How much can the Fed influence affordability? That depends on the loan terms, credit profile, etc.  But for simplicities sake, consider a $200,000 mortgage at 7% interest pretty standard in the middle of 2006 to the same mortgage at 4% rate pretty standard for much of the past 18 months.












As you can see the payment for the same home at the same price was roughly 1.5 times more expensive, or less affordable in 2006.  Another way of looking at it is that for the Payment to be roughly the same in 2006 as today, the house would need to be under $150,000.  I don’t think I need to explain the artificial pricing implications of allowing leveraged assets to be 50% more affordable than they were just a few years ago.

In fact, the Fed has served as Margin Lender for the world.  By holding interest rates at unprecedentedly low levels they have essentially increased the affordability of everything, at least everything borrowed.  This marginally influences productivity in a direct manner because it doesn’t directly affect productive capacity.  As we’ve discussed in the past, money tends to flow through the path of least resistance, with productive infrastructure being on the opposite end of the spectrum.

I think Investopedia sums it up pretty well:

1Investopedia explains ‘Margin’


  1. Buying with borrowed money can be extremely risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at a hefty price – the potential for greater losses.


I wish this were a novel idea, but it’s not.  Indeed the 5% drop in equity prices this month is due in large part to the fact that the FED and other central banks around the world gobbled up the excess leverage all while making it oh-so affordable to leverage right back up.  High priced, highly leveraged assets WILL be volatile.  One doesn’t need to go far for proof, just look at emerging market currencies.  Yes the world is still leveraged and yes the central banks around the world have enabled it.  That said, we do not expect the Margin Clerk to raise margins anytime soon.  So despite the wild ride that may come, we fully expect the path of least resistance to be higher.  Our outlook for the next quarter has a few adjustments from the past quarter with more emphasis on two-sided trade:


  • Fixed income in the duration of 3-5 years appears to be the sweet spot for yield, particularly if you can hedge yourself in the futures or other derivative.  Avoid anything longer than 5 years.
  • Although the Fed is pulling back they are still present, keep that in mind.
  • Have exposure to physical assets (particularly those with deep-retracements) in addition to equities.
  • Maintain a nimble portfolio, as volatility will likely increase as will risk as asset prices increase. If you tapered your longs down as recommended, look for value areas which will be present in 2014.


2013 was an anomaly of sorts caused by a Margin Clerk who was also the biggest purchaser of the very assets they were setting the margins on.  Although, they are winding down their purchases, they will continue to hold the affordability of these assets near all-time lows.  Granted this does provide good buying conditions, but be careful not to misconstrue great affordability, with great pricing.


Best Regards,


Duane Cronin