Rick Bookstaber on the Risk of a Leverage Liquidity Cascade

What is your take on the level of risk in the market? One of the things that you looked at is margin leverage. It's not a risk that a lot of market pundits spend time focusing on, but it's on your mind. Why and what are the specific metrics that you watch and what are they telling you?

The reason that leverage matters is that if something goes wrong in the market, the people who are forced to get out are the ones who are leveraged. It's either a margin call or something akin to a margin call. When you have more leverage in the market, you have more risk that if some event occurs that forces people to sell, you have increased selling, and then you can get what's called a “leverage liquidity cascade.”

People have to sell because they get margin calls. As they sell, that drops the price even further. As prices drop further, there's more of a need to sell. You get a cascade. It gets worse than that because if a market's dropping and dropping, it dries up in terms of liquidity. If you have to raise cash because of a margin call, if you can't sell what you want to sell, you sell whatever you can. You go into another market, and you start to sell there. You get contagion from one market to another. Ultimately, leverage is like kinetic energy. It's sitting there, and if some event occurs it can lead to both a cascading downdraft in the market and to contagion from one market to the other.

What is the level of margin telling you now, particularly in the U.S. equity market?

There's a lot of measures you can use for leverage; margin debt is the most immediate one. If you look at margin debt versus free-cash balances, which is the other side of the equation, it's at an all-time high. If you look at margin debt as a percent of GDP, it's at or near an all-time high, and you can get broader than just pure margin debt. I look at the share of household wealth in equities – that's a measure, not of literal leverage, but how far are people over their skis, so to speak. That's also close to an all-time high.

You can see why this would be the case. With a market doing as well as it is, everybody's willing to be a little more aggressive, hold a little more equity than they normally would. If you have the capacity to do it, you borrow money or lever, to be able to increase your return. These are the metrics that are there to look at.

Are there specific scenarios that relate to leverage that could lead to one of these leveraged liquidity cascades that advisors and their clients should be on the lookout for?

There are scenarios that can do it, but what's important is to realize that any scenario, or any risk, is a combination of two things. One is the event. There are some events that create a shock to the market. The other is the vulnerability of the market to that shock. For example, that is whether you think that the FAANG stocks – Facebook, Apple, and so on – are in a bubble territory, whether you think inflation expectations may lead to a big shock in the equity market. That's part of the story. But for any of those shocks that might start an avalanche, it's a vulnerability of the market that dictates where that avalanche takes hold and continues to go down the mountain. Part of the vulnerability comes from leverage. I don't think you have to point to any one scenario and say, "Aha, if that scenario occurs, leverage will be a problem."

It's any scenario that could trigger a drop, say of 10% or more in the market so that the leverage cycle takes hold. But if you're going to ask me, "Okay, well fine, but what scenarios are you worried about?" Top of the list of course is inflation, which is interesting because two years ago, if you had talked about inflation, people would have thought that you had three heads. But another one is whether we are in some type of a tech-oriented bubble. I don't like to use the term bubble, but when you see P/Es at the level they are, you can't help but think that we may be getting in a world of irrational exuberance.

Tied into that concern around a tech bubble has been the prevalence of speculative activity, such as the trading in so-called meme stocks and special-purpose acquisition companies (SPACs). How has that affected your view of the level of risk in the market? Are there models that can incorporate the behavior of that type of speculative activity?

This is an interesting point. Let’s look at what are called the meme stocks, SPACs, and I didn't even go into cryptocurrency or NFTs, non-fungible tokens that are being used to buy things online. They themselves may not be the risk to the market, but they're the canary in the coal mine that suggests we're in a period of speculative fervor.

We have these innovations that in a rational world, somebody would say, "Are you kidding? People are doing that?" But now people are doing it, and nobody seems to mind. That's an indication that things might be a little frothy. I've focused on these, not because I think short-term SPACs are the CDOs of 2021. They're not what the CDO's were in 2008. But people are into these things similar to the activity in meme stocks. A few years down the road if we look back at today, will we be shaking our heads, looking at these sorts of things, asking, “What were people thinking?”

To be clear, a CDO is collateralized debt obligation. Those were the primary culprit in the lead up to the great financial crisis. What I hear you saying is that leverage is the ultimate root of risk in the market. Are there steps that regulators should be taking to reduce the amount of leverage that would be more aggressive than whatever steps there are in place now?

They already did that after 2008. The Volcker Rule that you mentioned indirectly attacks leverage as an issue, but within the broker dealer community. One nature of the market is that we're very innovative and people can always arbitrage their way around a regulation, and regulations take a while to take hold. When we're at a period where there's an issue, it's a little late for regulation to try to come in and stem the tide. I don't think the solution at this point is regulation. Regulation usually has to be justified anyway by an event. If everything's just swimming along fine, a regulator can’t come in and say, "Nothing bad is happening, but I'm kind of worried." It's just not going to happen.

The key thing, if you're an individual investor or advisor, is to look at your place in the ecosystem and realize that although leverage is an issue, it's not an issue for you, since a typical individual is not leveraged and can't be forced out of the market. If you understand the dynamics that might occur because of high leverage and how people may be forced out of the market, and you'll get this firestorm of prices dropping, and that leads to further selling, you can prepare yourself for it and just step back and say, "Okay, I get it. I understand the dynamic that now is taking place. I steeled myself forward. I don't have to be involved. I can watch it happen. The dust will finally settle. People who were levered will finally be out of the market and things will go back to where they were."

A real advantage for an individual is that they're not a hedge fund. They're not leveraged. They don't have to mark to market and account to their investors every month. If they understand these risks, they can step back from them. If they understand them well enough and have the wherewithal and the risk tolerance, they can be the suppliers of liquidity, so to speak. When prices are down five and 10 and 15, and then 25%, they say, "I get it. People are screaming for liquidity, they have to sell, I'll provide it and be able to get into the market with a downdraft."

It's not so much regulation that can protect you. It's the very nature of the timeframe that you have in your investing and the structure of your portfolio.

Is that the fundamental difference between individuals and institutions, when it comes to risk management and their investing discipline, the ability for individuals to be able to be more flexible with their mandates and allocations?

Yes. There are two things that distinguish individuals. All of the risk management focus has been on banks, broker dealers, hedge funds; they all have a very short time horizon. All they care about is returns. They all lever in one way or another. For an individual, it's different. You have a longer timeframe, you're not levering. You're cutting with a scissor, not with a knife. Returns are not the only things that matter to you. You also have goals. You have your own risk tolerance, the way that you change in your views towards investing, and your time to retirement.

You can't take a risk management model of a bank or hedge fund and apply it for yourself as an individual because you're different both in timeframe and the fact that you are not looking just for a return, you're looking at returns in the context of goals. It is ironic that individuals have not been well-served with risk management. But, risk management is more complex for an individual than it is for a hedge fund. Because of the reasons I mentioned, it's a lot harder to manage risk when you're looking at years than when you're worried about what's going to happen over the next month.

It's interesting that you say individuals can look out over a longer timeframe than most institutions. Usually the counterargument that's made is that institutions, endowments in particular, have an almost infinite time horizon that they can look at. But at the same time, they're constantly being measured by quarterly performance goals. That introduces a conflict of challenges.

When I was at University of California, its pension endowment was about $570 billion. It's surprising how big it is for a public university. I look at the endowment and the pension fund there as if it's an individual for the reasons that you mentioned; the liabilities are far into the future. The trick is the thing that you mentioned: If you're called to account every quarter as if you're an investment management company, then you're missing part of the big advantage that you have as a pension, just as you do as an advisor for an individual. A lot of that finally rests with the quality of the board. If you have a strong board that understands the nature of your liability stream, you should be able to do the same thing an individual can do and not have to manage to the month or to the quarter.

I want to come back to the point that you made that advisors should be very wary of leverage and be concerned about one of these leveraged liquidity events unfolding, and perhaps adjust their allocation accordingly. How are your personal assets invested? What is your broad allocation to equities versus other markets?

It's kind of funny because the best investor in my household is my wife, who's been knocking out 40% and 50% annual returns because she doesn't follow my advice. She's been really aggressive in Apple and all the other stocks. I'm a pretty tried and true conservative. Any advisor looking at what I'm doing would probably say, "Yeah, okay, I get it." As I've gotten older, I've moved more and more away from high beta. The beta of my portfolio is about 0.7. I've lost a lot of returns over the last few years because of it, but I get it. I understand that. I'm willing to sit with that. I follow my own advice in terms of being a conservative, risk-management-oriented person. But I have the counterbalance of what my wife Janice does.

What, if anything, can advisors do to prepare their clients both mentally, and in terms of portfolio positioning, to manage the risk in case of a rapid de-leveraging event?

There are two things. One of them is so obvious that you hardly have to mention it, which is being diversified, because typically one of these events is going to be focused in one area. Of course, it spreads, but one area can be a hit far more than others. If you look at the internet bubble, the market went down, say 45% or so, but the internet stocks themselves were down over 70%. If you look at 2008, the market was down about 55%, but the banking stocks were down 70 to 75%. There's always some prime mover and you want to be diversified away from it. The other thing is to be prepared, understand how this might play out and not get caught up in the middle of it. If you're an advisor, make sure that your clients see that this thing can occur.

As it's starting, it's not like it'll happen without any sort of information. You'll be able to see that it is playing out and be able to have some competence in stepping back.

There's a third thing, which is if you're passively invested in a standard index, you are market-cap weighted and you implicitly are not well-diversified. In fact, you're non-diversified in the wrong way, because the high-cap stocks are the ones where there's the greatest concentration and the biggest potential of a problem. If you can pick your own benchmark, it's good to move away from cap weighting, because cap weighting basically means that you're in a momentum trade and you're going with the momentum of these large stocks going up higher and higher with the S&P 500. The top 10 stocks are about 25% of the total market cap. If you go to the NASDAQ, it's almost double that. Besides these other two things, being careful about the implications of market-cap weighting is also important.

I know that you're a big believer in factors as the most effective way to evaluate market risk. Why is that? What are the models that you're developing with Fabric RQ?

To give a sense of why factors matter, factors are the building blocks of risk, and every stock is affected by different factors. It may be value-oriented, in China, or in technology. It has all these factors that go into it. If you were looking at factors, you now are extracting the essential elements that create the compounds of each stock and seeing in aggregate, when you boil all this stuff down in your portfolio, how much exposure you have to this style, sector, country, rates and so on. For risk purposes, in the institutional area, factors are the standard approach. I'm naturally focused on them in what we're doing. We have the advantage of having a partnership relationship with MSCI. We can provide advisors with the MSCI factor capability and its models.

We can give a very strong, institutional-level view of factor exposures. This isn't to say that you can't look at risk on an asset basis; that's fine to do. But you're missing certain characteristics of how risks can thread across the range of your portfolio. The other thing is because they are the elements of risk, they tend to be more stable. The correlations of stocks go all over the place. If you're looking at your portfolio, you can't depend on the correlations that the stocks have had historically, because they change all the time. Factors are more stable. If you're looking at the interrelationships and correlations on a factor level, you can do that with more of a sense of what you're looking at today being a good representation of what might be happening going forward.

What is it that's unique and distinctive about the MSCI factors? If a client comes to you or comes to Fabric RQ, what is it that your analysis will tell them?

The key thing is you can either look at it in factor or asset terms. The key thing that we're trying to show people is not rocket science in the sense that, "Oh my gosh, I need to get a degree in math to do this." It is looking at risk in a way that all of us understand is common sense. In fact, we know better what we need in terms of risk than a lot of the risk systems that we use do. One common sense thing is that I want to know what's going on in the market now to understand my risks, not what's happened over the last one or two years. You can't use history as the guide for what risk will look like going forward.

You want to look at things like the leverage liquidity concentration of the market as it stands now, not what's been going on for the last few years. The other thing that you want to do is put things into factor perspective so that you can understand the way that risks might be transported or thread through your portfolio. The most important thing about risk is risk isn't really a number; it's a narrative. It's a story that has twists and turns as you go along the road. We use a framework where you can put risk into a narrative. I've been the chief risk officer at different institutions, and when there's a risk issue that we're discussing, and it doesn't have to be a monumental 2008 type of thing, we'll all get around a table. I'll be there. The portfolio managers, the heads of the trading desk, and the CEO will be there. What we'll end up doing is building a story. One person will talk about what they're seeing. Another one will add to it, and we're constructing what right now is a work of fiction, but it may turn into a work of reality.

It's not like somebody marches into the room and says, "Ah, the risk is 12.7. Okay, we're all done." A key part of a risk approach is to look at the market as it stands today, to look at forward risk, to do it with the language of risk, and determine the risk factors. We recognize that we're human and the markets are dynamic. My bet is that all of us do that, left to our own devices, We all understand that. But the risk systems, because they're built by statisticians who want to keep things in a mechanistic-number way, miss that point. The way I look at risk is, it's human plus machine. It's not just a computer; there's the human component because the markets are human.

What is special about the approach that you use with these MSCI factors?

What we can do with them is essentially drill down into a portfolio to better uncover the essential components of risk and those components as they span the different assets in the portfolio. They don’t just look at, say, 200 different stocks and try to figure out how they interact; are they more exposed to a move in high cap or to China than the U.S.? You can look at the factor exposures and see how much weighting each stock has to value, or how much waiting it has to China. It's not just, "Oh, it's a Chinese company." It's my supply chain is coming from China, or my customer base is in China. All those things will be wrapped into say, the China factor and how it's loaded onto your different stocks.

Where is Fabric RQ now in terms of its development and deployment? Is it commercially available? Can our listeners sign up for it, or where should they go to find out more about it?

You can sign up for it now and get a demo. The actual product will be out early September. Our website is www.fabricrisk.com. If you go to that page, you can sign up for a demo. You also can see a video of me explaining what we're doing at Fabric and a little 60-second piece.

If there's one key takeaway that you would like to leave our listeners with when it comes to how they should think about risk in the overall market and in their client's portfolios, what would that be?

There's two ways to look at it. What should you be worried about? And how should you approach risk?

What should you be worried about right now? That always changes, but not how you should approach it. Look at the market as it stands today, and try to understand its vulnerability, as opposed to looking at what may have happened in the past and think that the future will look like the past. Realize that, to understand risk, you have to turn it into a narrative. You don't want to be basing it just on a number. You want to think of risk the same way you think of investments. You don't boil down an investment you're doing into just a number. You have some numbers, but there's a story behind every investment. There's a story behind every scenario and possible risk. You want to think about things in those terms.

Read more articles by Robert Huebscher