The Global Margin Call

We’ve been tackling some pretty heavy issues in Daily Profit this week. And while I’m not one of the doom and gloomers who believe that stimulus policies and sovereign debt issues are about to bring about a stock market crash and economic depression, I’m adamant that we keep a firm grip on the all of the catalysts that are driving the stock market and the global economy.   

 

Stimulus policies in the U.S. were designed to help prop up asset values long enough for demand to return. If the plan succeeds, then employment will improve, lending will pick up as the housing market works off inventory, and the toxic assets that exist on the balance sheets (both banks’ and the Fed’s) can regain some value.   

 

If the plan fails, then we see another fire-sale of assets in what amounts to a huge margin call.   

 

If you’re not familiar with a margin, you should be, because it’s a very easy way to understand what happened to the stock market in 2008, and what could happen again.   

 

Margin is leverage. If you have a brokerage account with margin, it simply means that you can borrow against your existing stock holdings to buy more stock. (The amount you can borrow is usually 50% of asset value.)   

 

So for instance, if you have $100 in stock, you can borrow $50 against that stock to buy more. The stock acts as collateral.  

 

In a rising market, margin can be used to make more money. But in a falling market, it can be devastating.   

 

Say your initial $100 investment falls to $90. If you’ve used margin, and borrowed 50% against that original $100, you now owe your broker $5 (90 * .5 = 45). If you don’t have cash on hand to cover the margin call, your broker will sell some of your stock holdings.   

 

That forced selling can send stock prices lower, resulting in another margin call. It’s easy to see how this situation can snowball into an outright panic.   

 

I don’t mean to get into an elementary discussion of a concept with which many of you are no doubt familiar, but the margin call example is the simplest way to understand how the S&P 500 traded down to 660 in march 2009.   

 

The global economy was highly leveraged. And, in fact, it was leveraged against mortgage backed assets that, in many cases, were improperly rated by ratings agencies. So the holders couldn’t even make a rational assessment of their risk (not that many institutional investors were trying to make rational assessments.) 

 

Housing values started falling and it set of chain of margin calls that brought down Bear Stearns, Lehman Brother, and the pretty much every single asset in the entire world.   

 

(As an aside, I don’t use margin and I don’t recommend it for anyone. Period.)   

 

The bad news is that there’s still a lot of leverage in the system. That’s why interest rates are low. That’s why banks are reluctant to lend. And it’s why the Greece situation has spawned a mini-panic. 

 

There will always be leverage in the system. That’s the result of a fractional reserve banking system. We can debate the risks of that system, especially when it comes to the abuse of that system we saw during the housing bubble, but there’s no doubt that fractional reserve banking encourages growth.   

 

Now, the good news is that leverage has been reduced, and is still being reduced.   

 

So the bottom line for long-term investors comes down to belief. Do you believe that the U.S. economy can bounce back from its mistakes and set the stage for a new era of growth? Do you believe that the innovative spirit and intellectual property of U.S. companies and workers can continue to produce products and services that are the envy of the world?   

 

I vote an unequivocal and enthusiastic yes.   

 

Right now, one of the best investments you can make is in the companies that are helping America meet its energy needs. Like the companies that are using innovative drilling techniques to tap into one of America’s great oil reserves in the Williston Basin/Bakken area of North Dakota and Wyoming.  

 

ConocoPhillips (NYSE:COP) is there. And Hess (NYSE:HES) is also drilling in the region. But it’s the small “wildcatter” stocks that will bring you the biggest returns on your investment.  

 

I just recommended a stock to Energy World Profits that’s moving from a $0.03 loss in 2009 to a $0.14 a share profit in 2010 and $0.38 a share in 2011 – all because of its Bakken operations. Needless to say, it won’t be a $4 stock for long. In fact, a move to $7 in the next few months looks likely.   

 

I teamed up with world-renowned energy economist Gregor Macdonald to create Energy World Profits. And it’s giving investors a profit-oriented perspective on the energy markets that you simply can’t find anywhere else.  

 

Learn more about Energy World Profits HERE. You won’t be disappointed.