Dow Drops 600 Points: Uncovering Stock Market Danger

On Tuesday, the Dow Jones Industrial average skidded over 600 points intraday. That followed a Black Friday session which saw stocks get hammered as well. What’s going on?

One factor that analysts warned about recently are the historically high levels of margin borrowing.

Indeed, the recent stock plunges reveals the fragility of the uptrend in stocks and underscores how quickly the market can reverse.

If you are unfamiliar with margin buying, it is a strategy that investors can use to buy stocks – using borrowed money. The problem? When stocks fall, those investors often panic and rush to sell or – even worse – get a ‘margin call’ from their brokerage firm requiring them to exit their positions, often at a loss.

Margin borrowings in October were up 42% versus a year ago levels at $935.9 billion, The Wall Street Journal reported on November 28th, using data from the Financial Industry Regulatory Authority, Wall Street’s self-regulator.

That’s a lot of borrowed money driving the recent stock market gains. And, those investors are quick to pull the plug, which can partly explain the pace of the stock market declines on Black Friday and on November 30th.

How does margin buying work? Typically, investors with as little as $2,000 in securities in a brokerage account can use those assets to get a loan, or approval to borrow money and ‘buy on margin.’ If those positions turn against them, the brokerage firm makes a ‘margin call’ requiring them to either put more money into the account or sell the stocks to pay back the loan. That adds to the flurry of selling on days the stock market is down big.

This year’s jump in margin buying is just another warning sign, along with high valuations, that the current stock market euphoria is a delicate house of cards, vulnerable to crumbling quickly.

The Bottom Line

Stock market pullbacks can be scary experiences for investors. What we are seeing now could be the canary in the coal mine. The stock market uptrend is vulnerable. Inflation is rising. The Federal Reserve is warning it may remove monetary accommodation sooner than expected. And, investors have been using borrowed money to play the stock market. If you are concerned, there is a proven strategy to reduce your risk.

For many investors, gold is the answer.

Investors who seek to create a properly diversified portfolio need to include assets that are non-correlated, or those that will rise when others fall. Gold is a non-correlated asset to equities and can help provide effective portfolio diversification. Typically during severe equity downturns, the price of gold has risen often substantially.

During periods of severe stock market stress, gold has traded significantly higher. When the S&P 500 has collapsed by more than 4.4% in a week, or the equivalent of declining  by more than two standard deviations, the correlation between stocks and gold drops to -0.15 or -15%, according to the World Gold Council. What this means in plain English is that when stocks fall, gold prices tend to rise. When stocks fall quickly and sharply, gold tends to increase in value even faster as investors turn to the precious metals as a safe haven.

Holding as much as 10% of your portfolio in gold has improved long-run performance returns, according to research from the World Gold Council. It helps investors manage risk and smooth returns, especially during periods of stock market volatility or downturns.

As an investment, gold is considered a safe harbor and offers individuals the opportunity to preserve and grow wealth, especially when other asset classes aren’t performing as well. Gold acts as an insurance policy, a hedge against equity market declines and a vehicle to protect and grow wealth. This paid off for gold investors after the 2008 global financial crisis when gold went from $700 to $1,900.

Do you own enough?

Read More

Examining Stock Market Risk Right Now

Want to read more? Subscribe to the Blanchard Newsletter and get our tales from the vault, our favorite stories from around the world and the latest tangible assets news delivered to your inbox weekly.