Time to Avoid Leverage

May 24, 2004 – ‘Leverage’ is a generic term applied to debt that is applied to and used in trading and investment positions. For example, if you use $10,000 of your savings to buy stocks, and then use these stocks to borrow another $10,000, you have leveraged your position. Or as it applies to gold and silver trading, if you buy a futures contract and don’t have the cash in your account to back up the face value of the contract that you have purchased, you are again using leverage.

Leverage cuts two ways. In a bull market it helps you make a greater return on your invested capital. But the downside is that if you don’t get your timing right, leverage can hurt you in a bear market. For example, assume you have a $200,000 portfolio of stocks, half of which were purchased with borrowed money. If your stocks decline 25% on average, your investment actually declines 50% after you pay back the $100,000 borrowed to leverage your portfolio.

Hence, leverage is a dangerous game when used in trading and investing, and consequently, I don’t recommend it. When I recommend trades or investments in this letter, I recommend that they be fully paid for, and that leverage not be used. Nevertheless, I know that a lot of people don’t agree with my conservative stance. In fact, the majority of the hedge fund community is very aggressive in their use of leverage.

Remember the Long Term Capital Management fiasco? They were leveraged 132-to-1. In other words, for every $133 in their portfolio, $132 was borrowed. Their case was no doubt an extreme, and most hedge funds leverage themselves 2 to 4 times. But even these ‘relatively low’ levels of leverage can kill your results if you get caught on the wrong side of the market.

Anyway, you are no doubt asking yourself why I am delivering this big lecture on leverage. The answer is that I think the stock market is ready for a big collapse, maybe a 1987-type crash even. Therefore, you do not want to use any leverage in this environment. I’ll discuss this point as it relates to gold in just a minute, but let’s first look at the stock market.

I could go through the whole list of reasons that make me bearish, but most of you already know them or can figure them out. Just to give you a couple of points, the technical indicators are looking horrific – bad breadth is perhaps the most glaring weakness, but stocks no doubt are still way overvalued by any prudent historical valuation measure.

The accompanying chart is also pointing to a potentially scary technical picture. The rally in the Dow Industrials stopped right where one would expect it to, and we consequently sold short the DIA, SPY and QQQ. But look at this chart. It looks like the Dow will collapse back to last year’s lows, and probably beyond, which is the reason I am so concerned about leverage.

If there is a stock market panic, there will be a rush for liquidity. Investors – and the banks that hold the collateral securing the debt that they loaned to investors to leverage their positions – will sell everything they can if the price of the collateral starts declining. Because stocks are a popular and frequently used collateral for trading, banks watch stock prices closely. If the value of the collateral the bank holds starts to diminish and the prospect appears to the bank that the borrower has few resources available to put up more cash to support his trading or investment position, then the bank protects itself by selling the collateral, which is the key point. One popular form of collateral is gold, and to a lesser extent, silver.

Remember the immediate aftermath of the 1987 stock market crash? I remember it vividly, perhaps because my readers and I were on the right side of it. But here is what I wrote after the crash in Letter No. 14 on November 2, 1987:

“We have just begun what most people in the market today have probably never heard of, let alone experienced. It is a ‘liquidity crisis’. The last one occurred in 1974,but if you missed that one, you may have read in monetary history about liquidity crises of the past.

A liquidity crisis can be one of the most frightening and gut-wrenching experiences that you will ever encounter. Markets thrive on fear and greed, and in a liquidity crisis, it is the fear that takes hold…

During the first stage of a liquidity crisis, there is a rush to cash and cash equivalents. People sell stocks, commodities and even the precious metals, and place these proceeds in T-Bills and T-Bonds, as they are perceived to be both safe and liquid…During the second stage, the T-Bonds are sold because people become more aware that they have an interest rate risk, and the proceeds are moved into T-Bills. Finally, as the crisis deepens, people move into gold because they fear for the purchasing power of paper money.”

Our monetary system is due for a severe shock. In fact, it seems safe to say that it is long overdue because debt at all levels has grown to unsustainable levels. An overvalued stock market may lead to a collapse that could be the trigger that gives the monetary system that severe shock – the first liquidity crisis since the 1987 stock market crash. And therefore, please re-read the few paragraphs above from my letter describing a liquidity crisis.

In the immediate aftermath of the 1987 stock market crash, gold fell. It declined because there was a rush to cash, so gold was sold along with other assets. Gold declined for a while, but as the panic deepened gold started climbing back, and soon was over $500 per ounce.

If the stock market collapses from here, which I consider to be a good possibility, gold may also incur a setback – not a collapse, but just a setback – along with stocks. Gold will for a while get sold along with other assets in a rush for liquidity, which explains my admonition about leverage.

Do not leverage your gold here. Do not use it for collateral. And more to the point, while you may not be interested in playing the short side of the stock market as I have been recommending, do not hold stocks here (except my recommended gold mining stocks, provided they are held without any leverage), and do not use stocks for collateral. There is too great a risk of a liquidity crisis occurring. It’s time to avoid leverage.