A Sign of Debt Deflation

A reduction in leverage hints at a changing attitude.

“It’s only when the tide goes out do you discover who has been swimming naked.”

That’s a famous quote attributed to Warren Buffett in relation to leverage in the financial markets. In other words, only when asset prices start to fall do you find out who has been financing their positions with borrowed money. I know that the Fed, other central banks and many others are trying to live in a fairytale world, but borrowed money, in the end, either has to be paid back or defaulted on. When borrowed money has been used to fund asset purchases and then those assets begin to fall in value, that is when the real debt deflation spiral begins. You have to sell assets to pay back the debt, the assets go down in value even further, so you have to sell even more assets, and so on and so on.

Therefore, it is interesting to note that a key measurement of financial market leverage has just turned down. The U.S. Financial Industry Regulatory Authority (FINRA) publishes statistics showing the “debit balances in customers’ margin accounts,” which is a reflection of the amount of leverage that individuals and firms are using to invest in the stock market. Having decreased in March 2020 as stock markets collapsed, margin debt then expanded for 16-straight months, taking it way beyond the previous high point of May 2018. However, the latest stats show that margin debt decreased in July. This could be a sign that a more cautious attitude is appearing.

Of course, that doesn’t have to mean that asset prices will decline, but, having acted as fuel for the rally, a reduction in leverage should make us sit up and take notice. If, as we anticipate, asset prices start to decline, we fully expect margin debt to collapse as debt deflation takes hold.