Amidst Elevated Optimism And Record Margin Debt, Investor Reaction To 4Q Results From Top 6 Companies This Week And Next Telling

Bull markets survive as long as there is someone – a greater fool – willing to pay a higher price. As soon as the Greater Fool Theory breaks down, speculative bubbles burst. But before that happens, there is money to be made, which is what drives bullish sentiment.

Ahead of December-quarter earnings from major tech outfits this week and next, non-commercials meaningfully raised net longs in Nasdaq 100 index (mini) futures. As of last Tuesday, they held 31,611 contracts, up 54.9 percent week-over-week to a 27-week high (Chart 4).

Concurrently, there has been a massive increase in willingness to take on leverage.

In December, FINRA margin debt jumped $55.9 billion month-over-month to $778 billion – a fresh record. This came on the heels of a $62.8-billlion m/m surge in November. In those two months, the S&P 500 Large Cap Index shot up 14.9 percent, and the Nasdaq 100 16.6 percent. With five sessions to go this month, they have rallied 2.3 percent and 3.7 percent respectively.

As Chart 5 shows, the correlation between margin debt and the S&P 500 is tight – coefficient of 0.929 in the case of the S&P 500 going back to January 1997 and 0.873 vis a vis the Nasdaq 100 (the latter not shown here).

The chart also shows that margin debt cuts both ways. It helps on the way up as much as it hurts on the way down. Once trades begin to go the other way, margin calls can be costly, setting in motion a vicious cycle. The tipping point never comes with a warning. With that said, truth be told, it has paid off to lever up – so far. As long as they have an exit strategy, traders with the proper skill set can ride this crazy wave profitably.

Professional money managers are all in. At least going by the NAAIM Exposure Index, which measures National Association of Active Investment Managers members’ average exposure to US stocks, optimism is at a very high level – nearly lopsidedly bullish.

With three weeks in, the index is up 30 points in January to 112.9, which is only the second highest reading after 120.6 recorded in December 2017. Going back to July 2006 – encompassing 760 weeks – there have been 27 100-plus readings, seven of which occurred since mid-November, or 11 since mid-August. That is how persistently elevated this metric has been (Chart 6).

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