Sunday, April 1, 2012

Quote of the Week from Irving Fisher’s remarkable work, The Debt-Deflation Theory of Great Depressions:

“Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.”
The first quarter of 2012 has officially come to an end with the S&P 500 logging its best quarterly performance since 1998. For the first three months of the year, the index gained an impressive 12%. With fears about a European debt crisis subsiding, confidence among investors that a new cyclical, and possibly secular, bull market is beginning is rising quickly. Each time the market tries to sell-off even 1% in a day, buyers jump in and reverse the trend. Analysts are also ratcheting up year-end expectations to match the intense rally currently taking place.

This combination of positive factors is seemingly creating an environment where investors once again believe they can’t lose. Central banks across the globe, most notably the Federal Reserve, have made clear the desire to push stock markets higher. Many investors believe the Fed will still engage in QE3 in the coming months, irregardless of high oil prices or rising inflation expectations. Overall there appears to be a strong level of complacency in global markets.

Nearly 80 years ago, Irving Fisher recognized the importance of private debt levels in exacerbating the inflationary, than deflationary effects of over-investment and over-speculation. As over-confidence once again stems from a perpetually rising stock market, investors are becoming more comfortable with increasing their level of debt. As the following chart shows, margin debt (blue lines) is following the stock market (red line) higher.

Source: (The Big Picture)

The last two market peaks, in 2007 and 2011, corresponded with margin debt rising above the $300 billion mark. Data for March, which has yet to be released, may show margin debt again eclipsing that level. Whether or not this signals another market top, the lesson of increasing debt is clear. When markets eventually turn, this borrowed money will accelerate moves to the downside.

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