You’re Paying Attention To The Wrong Interest Rate

Authored by John Del Vecchio and Brad Lamensdorf via LMTR.com,

Lamensdorf Market Timing Report – Special Edition

This special report by LMTR.com will highlight a few charts. Investors with a lot at stake should pay close attention to these gauges over the coming months. Failure to act on warning signs could be the difference between a comfortable retirement or years of slaving away at work. Investors have too much to lose to be asleep at the wheel.

Start by paying attention to the interest rate that matters. Chances are, you’ve watched the talking heads on TV. They are heavily focused on the Federal Reserve and what actions members plan to take on interest rates.

But, the interest rate that really matters is LIBOR. LIBOR stands for the London Interbank Offered Rate. It’s an extremely important rate.

When investors borrow money and use their portfolio as collateral, the loan is often priced at LIBOR plus some base interest rate. For example, the loan might be priced at LIBOR plus 1%. Importantly, these loans are not priced based on the federal funds rate.

Please note the blue line on chart below. The blue line is 3-month LIBOR, which has been rising steadily from the ashes to multi-year highs. Nearly every day it is getting more and more expensive to maintain these lines of credit that wealthy investors have been using.

How much credit is out there, borrowed against stock portfolios? Trillions of dollars.

People with portfolios of liquid assets, people who own stocks, have access to these credit lines. Often they must have more than $1 million in stocks and bonds to gain access to LIBOR-plus loans. These are the one percenters.

They can buy a new house or finance a large purchase of an illiquid asset by using their portfolio as collateral. These assets might be boats, planes, fine wine, or investable art.

You name it.

The rub is that the banks don’t ask you what you’re going to use the money for. The only stipulation is that it can’t be used to buy more stocks. Anything else is fair game. Want to have a great time in Montreal this weekend? No problem! Just tap into the line of credit. Need to charter private plane for a round of golf at Pebble Beach? The banks are happy to allow wealthy investors to tap the line of credit.

However, there is a problem. As interest rates creep up and more portfolios have been used to finance asset purchases, a huge storm can be created if stocks and bonds take even a minor dip. There’s an old saying that you can always buy a boat but you can’t sell one. This is the problem. Shedding assets when everyone else is feeling pain leads to terrible deals for the seller.

If stock prices slide, the borrower could get margins calls. They have to sell stock, but, they also have to reduce their leverage because they can only borrow so much against the portfolio. Everything unravels at once, accelerating the selling pressure. What should be down 10% in normal markets might be down 30% in a highly levered market.

With trillions out there, things could get nasty. What’s the tipping point? It’s hard to say but rates have really shot higher in the last year or two and things are getting dicey. There are a few more charts that investors should monitor to help detect warning signs and adjust investments accordingly.

First, investors as a whole are gorging like pigs at the trough. The credit balances on the NYSE are at historic levels!

Notice that investors had substantial negative credit balances just as the Tech Bubble was topping out. Then, after the market crashed, investors had a positive balance. They missed out on a huge buying opportunity.

A few years later, history repeated itself as balances turned negative during the housing boom. The mortgage crisis led to the largest positive balance in decades. History repeated itself, and investors missed a huge buying opportunity near the 2009 lows.

Now, as the stock market has practically gone parabolic, investors have taken on massive amount of margin debt. When this margin debt is unwound, like it was during the last two bear markets, it’s going to be nastier than before because there is so much speculation in the system.

Next, given that investors are using lines of credit against their portfolios to the tune of trillions of dollars, we know that we are not a nation of savers.

Take a look at net national savings and its potential impact on growth.

No fancy math is required to figure out that the trend has been declining. We are well below the savings rates from the 1950-1980’s. While we did dip into very negative territory 10 years ago, this was due to the financial crisis. Now, stocks are near all-time highs, yet, savings has declined again. We are at risk of turning negative during a market boom!

Where’s the money going to come from to meet margin calls if stocks take a breather?

Meanwhile, savings alone haven’t been enough to finance consumption. Sadly, nearly half of Americans could not fund a $400 emergency tomorrow. So, people have been taking on more debt. Credit standards are certainly looser. In fact, the subprime default rate on automobiles is soaring to new highs!

The chart below shows household debt servicing.

What we see is that low interest rates have really compressed debt servicing. Check out mortgage servicing (red line) in the lower panel on the chart, which is at generational lows. All of the metrics are extremely pressed, but, most of them are starting to trend up.

This could be a big problem.

The pain is coming and unavoidable. One day, the funding costs will become too much to handle. Right now, small changes in rates might not be noticeable. However, like boiling a frog in a pot, it all adds up.

Next is one of Warren Buffet’s favorite stock market indicators, the stock market capitalization as a percent of gross domestic income.

It’s currently through the roof, almost as high as the peak of the Internet Bubble!

Based on history, we are clearly in Bubble Territory. Years of low interest rates have manipulated the stock market higher and created an imbalance that is disproportionate relative to the general economy. When the market does get hit with another crisis or bear market, it’s going to be more painful than normal given its relative size to the economy.

Watch these indicators.

Closely.

They’re showing the affects of years of low interest rates. There’s a lot of leverage in the system and the margin for error going forward is razor thin. Investors with sizable portfolios have the most to lose. But, they also have the most to gain if they can navigate the market unemotionally and be greedy when others are fearful as the next bear market unfolds.

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At LMTR.com we regularly post interesting charts (often only available to professional investors), quick-take podcasts on hot topics, provide simple analysis of complex topics, and track stock market sentiment. Join us, and feel free to offer your feedback at info@lmtr.com.

The post You’re Paying Attention To The Wrong Interest Rate appeared first on crude-oil.news.

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