Brace For a Leveraged Correction

We've seen unprecedented volatility on the ASX over the past few weeks. The intraday volatility is quite frankly, concerning, with the prices of many leading stocks moving through a range of up to 5% during the course of a day’s trading.

Puzzled by this rise in volatility I've had a very good explanation from a reader who has brought my attention to the growth of the Contracts for Difference (CFD) markets, and wondering whether this growth is playing a role in the unprecedented daily volatility we are seeing in Australian equities.

The answer is clearly yes. CFDs are a dangerous product in my opinion, and basically give retail investors unprecedented access to leverage. I think you are seeing retail investors and day-traders moving away from traditional margin lending products, with their 75% average gearing limits, to CFDs with their 95% average gearing limits.

That’s a switch from leverage of 3:1 to a massive 19:1.

The investor who wrote to me regarding CFDs believes "95% leverage to retail traders has not been available since the late 1920s in the United States and is still not available to retail investors there".

As I understand it, aggregate CFD growth is not included in the overall "margin lending" statistics put together by the Reserve Bank of Australia (RBA), and that in itself is interesting. The bulls keep telling me that "margin lending" growth is not rampant, and that we can't be at the trading top of the Australian equity market yet. The RBA reports total margin loan exposure in Australia at $20 billion, yet this masks the fact that retail investors have been abandoning traditional margin lending products in favour of the new higher leverage available in CFDs.

If this is the case, then it could be that the financial regulator APRA is asleep at the wheel, and overall leveraged exposure risks in Australian equities are much larger than anyone currently believes.

To quote our reader again: "I was recently bailed up in an eastern suburbs pub by an idiot CFD salesman from whom I would not buy a fake watch. I found this very alarming. I can't imagine how many retail investors would be using cash out of their homes to finance their CFD speculations. The margin clerks will be busy."

If you think what I am writing is alarmist, I urge you to log on to one of the CFD trader websites and see just how quickly and easily you can get access to 95% leverage. All I know is that market peaks are often associated with new forms of leveraged retail investor products being introduced, and I suspect the amount of genuine leverage in this market is completely underestimated.

Everyone is putting too much faith in the traditional "margin lending" data, yet I can guarantee you that when the correction comes, the amount of new-found leverage in the market will guarantee the correction is violent. It is impossible to get accurate data on the total exposure to CFDs in the Australian market, but gut feel and market action suggest the exposure is much larger than people suspect. (To read Eureka Report editor James Kirby's recent feature on the dangers of CFD investing, Dangerous Liaisons, click here.)

I want to again put on the record that now is not the time to be using leverage; it is actually the time to reduce leverage. Unfortunately, some retail investors are going to learn this lesson the hard way.

Yet leverage isn't just being used in Australian equities; it's clearly also being used in commodity markets. The classic signal was one session last week on the London Metal Exchange, where spot prices rallied despite all Asian metal consumers being on holiday. Asian consumers were out of the markets yet commodity prices rallied! That's telling you that leveraged speculators have got control of these LME markets, and that's a situation I don't feel comfortable with.

I strongly believe the Chinese will take more steps to cool their economy and attempt to take some of the speculative heat out of commodity prices. I think there will be a series of coordinated moves by the Chinese over the next few months to get the speculative heat out of commodity prices, and my view remains that those with close ties to the Chinese know this is coming. However, the hedge fund and leveraged trading community has no idea, and believes the copper price can only go one way: up.

It's taken three years, but you simply can't find a cautionary word on commodities or resource stocks from anyone. Everyone is on the bandwagon, yet as the great investor Jimmy Goldsmith said: "When you see a bandwagon it's too late."

I remain a long-term believer in the highest quality, long duration, large and mid-cap Australian resource stocks, but I also remain strongly of the view that the metals sector can't move sustainably higher until we have a solid trading correction that cleans out all the hot and momentum money.

I remain an unwavering bull on the gold, coal, and oil sectors, yet it's the metals sector where the really hot money is playing. There are even reports of hedge fund using other commodity futures as collateral for investment in metal futures. Sounds like a bit of a pyramid scheme to me. I just get the feeling the Chinese Government is going to test these people's commitment to the sector over the next few months.

CONFESSION SEASON

Interestingly, most of the recent production reports from the resource sector were a fraction worse than expected, yet in the "glass half-full" overlay we are operating in, the market saw this as positive because it meant overall commodity supply wasn't as strong as expected. That's a bit of a circular argument, yet again it reinforces how the market is seeing moderate news as positive news.

However, I believe it's always at the May board meetings when companies discuss their ability, or lack of it, to meet the markets full financial year expectations. So far we have already seen profit warnings from the domestic auto parts retailers, and warnings about the potential impacts of petrol at $1.40 a litre. We have seen the chief executive of one of the big banks '” John McFarlane at ANZ '” saying conditions are "as good as they get". We have also seen an expectation hosed down from PCH Group, which operates in the booming engineering sector.

I suspect more cautionary comments are coming from the industrial sector, and investors forget that this time last year we witnessed a mid and small-cap profit warning session.

I also believe that my conversations with listed and unlisted companies confirm management are more cautious of the future than the equity market currently is. They all talk about energy prices and the potential effects of inflation and higher interest rates.

INTEREST RATES

Well, I got that one completely wrong, and the RBA board did go with the "pre-emptive" strike on inflationary pressure. Roger Corbett voted against his own retailing interests, and the RBA flexed its independent muscle ahead of the federal budget. I have to admit, I am pretty surprised by this development today, and I think many in the market were too.

The domestic consumer now has to deal with higher interest rates, a higher dollar, and higher fuel prices, yet the equity market is currently pricing no risk in industrials over a risk-free government bond. Surely, today's developments confirm that equity "risks" are clearly rising, and I suspect today's interest rate rise will be the catalyst for the long-overdue trading correction to start.

The interest rate rise is the first headwind the market has truly had to deal with for more than 12 months, and when the market actually thinks about its potential ramifications, including a significantly higher Australian dollar, the correction will set in.

I recommend raising some cash, taking out some index protection, rotating to the highest quality long duration companies you can, and getting potential mid-cap lobster pots out of portfolios. Lower the overall price/earnings multiple of your portfolio, increase the prospective dividend yield via underperforming industrials, and add sustainable return on equity to your portfolio.