Thursday, May 12, 2011
Leverage is financial crack.
The first hit feels good. It's a trader's high... We want more of it. So we use it again, and again, and again – until we're addicted.
Then it takes more leverage to create the same high. We crave it. We need it. We leverage every position.
And then it kills us.
The use of leverage killed the returns of several hedge funds last week. They were all smoking from the same crack pipe. They borrowed money for next to nothing and leveraged their commodity trades. More oil... more gold... more silver.
It's a strategy that generated huge returns until it wiped everyone out. BlueGold Capital Management lost $500 million (roughly 20% of its capital) last week... and now shows negative returns for the year. Clive Capital, the world's largest commodity hedge fund, lost $400 million and is reported to be underwater for the year. Astenbeck Capital, the well respected Phibro-owned fund run by Andrew Hall, dropped 12% last week. And the list goes on.
The lesson here isn't anything new. Excessive use of leverage is bad. Oh sure, everything is wonderful as long as the market is moving in your direction. But one little blip, one small hiccup in the trend, can wipe out months – or even years – of gains overnight.
We saw it with Long Term Capital Management and Lehman Brothers when they went belly-up. We saw it with every major money-center bank during the financial crisis of 2008-2009. And we saw it in the commodities markets last week.
Now we're seeing it with brokerage accounts.
Margin debt on the New York Stock Exchange has surged to its highest level since February 2008 – just before the S&P 500 dropped by half. Net leverage on the NYSE is now the second highest ever recorded. The only time in history leverage has ever been higher was back in June 2007 – at the absolute peak of the credit bubble.
It seems like everyone is addicted to Wall Street's favorite drug – leverage. And everyone is going to suffer the consequences.
Last week's brutal selloff in the commodity complex caused a lot of damage. It wiped out a lot of gains and showed the dangers of excessive leverage.
Now imagine that same sort of action in the stock market. That's what all this excessive leverage is setting us up for.
Add it to the long list of reasons to be cautious with stocks right now.
Best regards and good trading,
Jeff's "list of reasons to be cautious with stocks right now" is getting longer and longer. Monday, he showed us how sinking copper prices forecast a downturn in the S&P 500.
And yesterday, Matt warned Canadian stocks have turned bearish. "I think the downturn will be temporary," he says. "But when it comes to trading these super-volatile stocks, you can't know the future. You can only stay aware of the risks, ride the up moves, be wary of the down moves, and protect your gains with trailing stops."
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