The Road to Financial Ruin
Breathtaking confidence... 'Folks are way offside'... Leverage is back in style... A great way to lose a lot of money fast... Being risk aware...
Humans aren't contrarians by nature...
They tend to think things will continue as they are indefinitely.
In the stock market, folks tend to be most confident when they believe a trend is confirmed by the market's action. So if the market has been going up a lot, investors think it'll keep going up a lot. They invent reasons to support their idea and become more and more confident.
Today, those "reasons" probably include the Federal Reserve lowering interest rates... President-elect Donald Trump about to "make America great again"... Elon Musk and Vivek Ramaswamy vowing to make the government more efficient... and tariffs on foreign goods (which are actually bad for American consumers, but most folks are economically illiterate).
Investors believe these things will keep stocks going up at roughly the rate they've been going up.
In the November 26 Conference Board Consumer Confidence Survey, 57.2% of respondents said they expected stocks to rise over the coming year. That's the highest result since the question was added to the survey in 1987. The latest reading, on December 23, was 52.9%, which is still in record territory.
So investors are highly confident that the bull trend is in place.
After all, they just watched the S&P 500 Index rise 23.3% in 2024 – its second straight year of 20%-plus gains.
The last time we saw the S&P 500 return more than 20% in two consecutive calendar years was during the dot-com bubble in 1997 and 1998. The S&P 500 went on to rise 19.5% in 1999.
So it's understandable that folks believe stocks will keep going up. In most years over the past several decades, stock indexes did rise. Based purely on history, the odds are better that stocks will rise than fall in any given year.
The problem is stocks never go up forever...
After 1999's stellar market performance, the dot-com bubble popped. The S&P 500 fell around 46% from the start of 2000 to the end of 2002. And when stocks tank like that, folks can make the mistake of selling out at the bottom in a panic.
Being a successful long-term investor requires surviving the inevitable downturns along the way.
Unfortunately, many investors are breathtakingly overconfident in the biggest mega bubble in recorded history. And they're setting themselves up for financial ruin...
Investors are in love with leverage again...
As our friend Jason Goepfert at SentimenTrader.com reported in a December 31 post on social platform X:
[There are now] 100x more assets in leveraged bullish funds than bearish ones, [for] the first time ever.
Goepfert says this is a sign that "folks are way offside," which I assume means too bullish.
It's as though stock market gamblers have pushed all their chips to the middle of the poker table and uttered the often-fateful words "all in." But with some exchange-traded funds ("ETFs") using as much as 4 times leverage, they're more than all in. They're 2 to 4 times all in.
This feels suspiciously like the investment-trust mania that preceded the 1929 stock market crash and subsequent bear market, where the Dow Jones Industrial Average plunged 89%. This led to the Great Depression – the worst economic downturn in American history.
Investment trusts back then were similar to leveraged ETFs today. They were publicly traded vehicles that owned a basket of stocks. The trusts bought their stocks with borrowed money... and sometimes trusts bought other investment trusts. It was leverage on top of leverage. And it didn't end well.
But investors today aren't just buying leveraged ETFs...
Goepfert also pointed out the leverage happening in the options market on December 31. Small investors – folks buying 10 or fewer option contracts at a time – had bought 250 call options for every 100 put options over the past 10 days. This is only the second time this has ever happened.
He also reports that nearly 50% of the opening daily volume of small traders has gone into buying call options, a level exceeded only by the 2000 and 2020-to-2021 options frenzies.
Small investors buy options because they don't have the patience to compound their money at reasonable rates over long periods of time. They want to get rich quick, so they pour money into leveraged ETFs and options (among other highly speculative bets).
And as you might guess, good old-fashioned margin trading is back, too. Goepfert reports:
For the first time in history, investors owe $500 billion more in margin debt than they have available in free credits.
That's sort of like saying investors have $500 billion more debt than available buying capacity in their brokerage accounts. That has never happened before. As the chart below shows, margin debt hit 2.7 times available buying capacity (U.S. GDP) in July 2024. The margin-debt-to-GDP ratio is currently at 2.6 times right now.
Despite higher interest rates – including higher margin rates – folks are borrowing money to buy stocks more aggressively than ever relative to their available buying capacity.
In short, investor leverage is hitting new all-time highs by some measures. Heavy leverage use is typical of toppy mega-bubble markets.
Buying securities with leverage is a great way to lose a lot of money fast...
Margin trading was a primary feature of the 1929 peak and subsequent crash.
Back then, many investors were little more than gamblers. They bought stocks on margin with as little as 10% down. So they could buy $100 worth of stock for $10 in cash. If the stock went up 10%, they'd double their initial investment. But if it fell 10%, they were wiped out.
And many folks were using margin loans to buy shares of investment trusts, the leveraged ETFs of their time. These actively managed, leveraged pools of capital tended to invest in whatever was hot at any given moment, as Edward Chancellor described in his must-read classic Devil Take the Hindmost:
They borrowed heavily against their assets in order to leverage profits... The high stock turnover in the trusts' portfolios reflected baneful trend-following rather than sober pursuit of intrinsic value. The investment banks, which sponsored the new trusts, frequently dumped stocks into their portfolios that they found difficult to sell elsewhere – as a result the investors diversified in junk.
One of the worst trusts was Goldman Sachs Trading Corporation, issued to the public in 1929 at a split-adjusted $52 per share. By 1932, near the bottom of the bear market, it traded at $1.75 per share, a decline of more than 98%.
There's no reason to suspect anything will be any different this time around. Investors buying leveraged ETFs, options, and stocks on margin today will likely see similar results.
Folks don't seem to understand that, yes, leverage offers the possibility of much higher returns than non-margin trading... but it also has a much higher likelihood of financial ruin.
None of this means I (Dan Ferris) am predicting a bear market this year...
With egregiously high stock market valuations... back-to-back stellar performance years... and huge increases in leverage, controlling risk should be investors' highest priority this year – just like every other year.
Sure, there are plenty of folks with seemingly infinite risk tolerances who have quickly made a lot of money on the stupidest, riskiest bets in financial markets.
But those same folks will lose it all – and more – when the inevitable correction, crash, or bear market arrives. Leverage schemes all blow up. Achieving great wealth through long-term compounding requires surviving the inevitable downturns along the way. If you use leverage, you will not survive.
Some may call me bearish. But as subscribers to my Extreme Value and The Ferris Report newsletters and Digest readers know, I'm simply being risk aware.
That makes me a lot different than the average investor, who thinks I'm an idiot because I haven't borrowed every penny I could and used it all to buy leveraged ETFs and call options.
Putting it all together...
Like all humans, investors are biased to believe that what just happened will probably happen again soon.
Right now, that means they think the stock market will go up another 20% or thereabouts in 2025. And they're more confident about it than they've ever been in the history of the Conference Board Consumer Confidence Survey.
So as we enter 2025, investors are using more leverage in more ways than ever before.
What could possibly go wrong?
New 52-week highs (as of 1/2/25): Alpha Architect 1-3 Month Box Fund (BOXX), CyberArk Software (CYBR), and EQT (EQT).
In today's mailbag, feedback on yesterday's edition on the "war at home"... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"I'm a long-term Stansberry subscriber and do read your commentary whenever I get it. What is missing from the reports on these two men is the state of their psychiatric treatment... This is what should be investigated." – Subscriber Cassandra A.
Happy New Year,
Dan Ferris
Medford, Oregon
January 3, 2025