The Mother of All Margin Calls Looming?”

by AvidTrader

Many investors think corporate earnings are the most important dynamic in regards to stock market valuation. Some feel economic growth (GDP) is. These are definitely important factors and have to be considered in the decision making process. What we have found to be the most important at any given time is liquidity. An abundance of cash/credit in the system can transform a decent earnings/economic environment into a stampeding bull market. On the other hand a lack of liquidity can take a mediocre situation and create a vacuum in the stock market.

The last few years have seen easy credit creating a bull market in real estate and the attendant mortgage paper that goes with it. Stocks, commodities, and global growth have been beneficiaries of the low interest rate environment also. The flip side of that run could be a significant contraction of easy money as lenders lick their wounds and tighten up lending standards. Often these situations can lead to swinging from one end of the pendulum (too easy) to the other (too tight) in a short period of time. A lowering of interest rates by the Fed may mean little as risk now dominates the decision making process as opposed to return. We are sensing that may be occurring right now? Try to refinance lately or know any mortgage people?

It appears to us that the brokers, bankers, hedge funds, and other institutions could be hampered significantly by this contraction. The value of AAA tranches of the Collateralized Debt Obligations (CDO’S) has dropped from $.96 to $.69 in a month (markit.com). We have read that some of these institutions were leveraged up to 20x their equity on this paper. That might be why Merrill Lynch pre-announced a few weeks ago that it would have a $2-3 billion dollar write off, then it went to $5 billion and by the time they officially announced it was $8 billion. UBS, Morgan Stanley and CitiGroup all took write downs recently and there could be more confessions coming.

So how do the bad debt investments made by large institutions negatively impact your equities portfolio? Well, in a few different ways: the contraction by lenders removes liquidity from the market probably leading to fewer private equity deals, stock buy backs by corporations (many were implemented with borrowed money), and a tighter mortgage/real estate market. The last dynamic could hurt the consumer significantly, which represent 70% of our economy. Second, all the above could lead to lower corporate earnings in the coming quarters. And third, the rapid declines in these leveraged investments could lead to margin calls for these institutions. When they get margin calls they tend to have to sell the good stuff (maybe stocks you own?) because it is most liquid. Many think this was the cause of the correction August. Buying opportunities do often follow.

We got a whiff that type of selling started last week as the heroes of the NASDAQ -- Apple, Google, RIMM, Baidu.com, etc. -- broke down rather significantly. We believe there could be more action like this in the coming weeks as the mother of all margin calls potentially plays out? We would not be surprised to see the Fed have to step in before its next scheduled meeting in mid December.

As we have been saying for the last few weeks this is a good time to be cautious and vigilant. It might be profitable to have some cash as the possible lower prices provide opportunities in the coming weeks/months. We have not seen such a worrisome array of chart patterns since the market bottomed in 2002. As the Hill Street Blues sergeant used to say “Be careful out there”.