The Buckingham Report

With the major market averages hitting multi-year or all-time highs in recent weeks, the nay-sayers have had to turn to new bogeymen to try to frighten investors into fleeing equities. The budget and trade deficits, the war in Iraq, the omnipresent threat of terrorism, the impact of rising interest rates, the bursting of the housing bubble, the slowdown in the growth of corporate profits and the backdating of options scandals have not done the trick, so the latest boo thrust upon the Street is the record level of debit balances held in margin accounts.

One well known weekly publication proclaimed, “The combined debit balances of the Big Board and Nasdaq have reached a record high of $303.29 billion. That tops the previous peak of $299.93 billion, set at the end of March 2000. Essentially, we view [this] as a profile in extreme speculation. And, as we saw in 2000, that kind of excess is typically the perfect prelude to a fall...How can anyone in a fiduciary capacity buy into this rally at this juncture?"

While I can’t deny that the numbers on debit balances are factually correct, I am afraid that the doom-and gloom crowd is omitting some key information from this margin discussion. For starters, the $303 billion figure is the combined debit balances held in accounts at NYSE-designated clearing firms and NASD-designated clearing firms. These accounts contain securities that are purchased on margin and while many of those are stocks that trade on the New York Stock Exchange and Nasdaq, margin accounts can also hold American Stock Exchange stocks, mutual funds, fixed income investments and options. The inference that the entire $303 billion is invested solely in NYSE and Nasdaq stocks is entirely untrue.

Nevertheless, some may say that we should not concern ourselves with the semantics as the point that is trying to be made is that speculation is running rampant, just as it was at the market peak back in the first quarter of 2000. Again, this is misleading and here’s why.

First, there is no context as to what type and amount of collateral is supporting the $303 billion in margin debt. I did check with the folks at NASD and there are no statistics available pertaining to the market value of securities held in those margin accounts and they suggested that I think about the issue like I would a home mortgage. Consider that there is a big difference between owing $500,000 on a $1 million house and owing $500,000 on a home worth $510,000, yet the amount of the mortgage is still $500,000!

Second, let’s take a look at my Buckingham Portfolio, which utilizes a modest amount of margin leverage. As of this morning, the account had stocks worth $210,572, equity of $203,744 and a margin balance of $6,828, yet the only number that gets incorporated into the statistics published by NASD is my $6,828 debit balance. Given that I have an equity percentage of 96%, I hardly think that I am being overly speculative as my equity is more than 29 times my margin balance! In fact, the table below shows the tremendous amount of additional securities I would be able to purchase in my margin account, if I so desired, given that my present cash available for withdrawal figure is $102,413.

While some will say it is not a fair comparison to draw given that margin accounts and credit accounts are held by different people and cash balances in the latter can not be used to pay off the former, I think the relationship between the two figures is germane to this discussion. Yes, there is no guarantee that if margin account holders liquidate, the cash account owners will dip into their reserves to take the other side of the trade, but all of that cash sitting on the sidelines provides tremendous liquidity to the financial markets.

Looking at the historical trends in the overall debit and credit balance statistics with this in mind certainly paints a far different picture than what the scare-mongers might have folks believe. Don’t get me wrong, clearly there is more speculation today than we have seen in recent years. However, with $299 billion in credit balances offsetting to a degree the $303 billion in debit balances, we are a far cry from where things stood in February 2000 and March 2000. Back then debit balances dwarfed credit balances by more than $130 billion! And as the chart will attest, this indicator suggested that there was far greater overall speculation back in 1997, 1998 and 1999 than what we see today.

To be sure, there are lots of things that could derail the recent market rally, but we do not think excess speculation in margin accounts is anything to worry about at this point, especially as $303 billion in borrowed money pales in comparison to the overall market capitalization of the U.S. equity exchanges. After all, the combined market caps of ExxonMobil, General Electric, Microsoft and Citigroup alone total more than $1.3 trillion! Of course, since the market likes to climb a proverbial wall of worry, we are never too disappointed to see bearish stories played up in the media.

As Paul Harvey would say, “And now you know the rest of the story. Good day!”

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There are certain risks inherent with the use of margin. Margin accounts are not suitable for everyone. You should understand that b uying securities on margin amounts to getting a loan from your brokerage firm to pay for your securities. When you buy on margin, you must repay both the amount you borrowed and interest, even if you lose money on your investment. Some brokerage firms automatically open margin accounts for investors. Make sure that you understand what type of account you are opening. For more information about margin click on this link: http://www.nasd.com/InvestorInformation/MarketsTrading/MarginInformation/NASDW_005927

Opinions expressed are those of John Buckingham, which are subject to change without notice and are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. Performance results of such recommendations are subject to risks and uncertainties including (i) national and international economic conditions and fluctuations, (ii) economic conditions of particular industry and service sectors, (iii) the ability of the management of the company whose security is recommended to perform and achieve expected results of operations.

Al Frank Asset Management, Inc
32392 Coast Hwy, Suite 260
Laguna Beach, CA 92651
USA

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About Al Frank Asset Management

Al Frank Asset Management, Inc. ( Al Frank ) is an Investment Adviser, registered with the Securities & Exchange Commission, is editor of The Prudent Speculator (TPS) newsletter, editor and publisher of The Prudent Speculator TechValue Report (TVR) newsletter, and is the Investment Adviser for individually managed accounts and two value-oriented no-load proprietary equity mutual funds.

Al Frank is committed to assisting our customers build wealth. We are a leading resource for value-based investor information in the financial community, where we combine our simple, proven philosophy of buying under valued securities for their long-term appreciation with our experience, hard work, and intensive research to give you actionable investment information that can be used on a daily basis.

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