Why you shouldn’t borrow to invest right now: Larry MacDonald

Low interest rates may be tempting, but beware the siren call of leverage

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Crystal ball, descending line graph and share prices

(Adam Gault/Getty)

With five-year rates on fixed mortgages as low as 2.99%, it’s not surprising financial advisors such as Ted Rechtshaffen are now recommending borrowing to invest. After tax, a lending rate of 2.99% drops to as low as 1.6%, a very low hurdle for a portfolio of stocks to clear. Alas, the basic problem with this advice is that it comes late in the stock-market cycle.

Stock markets around the world have been in a bullish trend for about five years, since the bear market bottom in early 2009. Many of them have more than doubled in value over that time. Some, like the S&P 500, have reached new historical highs.

Valuations are rich. The cyclically adjusted price-earnings ratio calculated by Yale University professor Robert Shiller stands at 25, compared to its average of 16.5 over the past century. The ratio of total market capitalization to Gross Domestic Product, a yardstick preferred by legendary investor Warren Buffett, currently reads 115.1%. Levels over 100% denote overvaluation, according to Buffett (at the last peak in the S&P 500, in 2007, the percentage was 135 per cent).

Borrowing to invest at this stage is just following the crowd—not usually a rewarding exercise in the world of stocks. For example, U.S. margin debt as a percentage of GDP now sits at 2.73%, surpassing the high reached in 2007 and closing in on the bubble peak of 2.78% in 2000.

In short, there are many red flags fluttering in the wind. They suggest anyone taking out a five-year loan in 2014 to invest in the stock market for the next five years will likely see some sharp downdrafts, rather than the fairly steady upward progression of the past five years.

Leverage is great to have when riding a bull market but hellish when the market is on one of its plunges. As David Chilton notes in The Wealthy Barber Returns, the “biggest problem with borrowing to invest is the psychological pressure borrowers feel …. It often causes sleepless nights, panicked exits or both. This is not a theoretical argument—I’ve seen it many times.”

Sure, you can say you’ll tough it out. However, to again quote Chilton: “Figuring out how much volatility we can stomach ahead of actually experiencing that volatility is an inexact process. For most of us, it’s less than we think. And for investments made with borrowed money, it’s generally way less.” The result, too often, is dumping one’s positions at the worst time, near the bottom of a bear market.

Paradoxically, the time to make leveraged bets on stocks is when most investors are rushing for the exits. For this market cycle, that was back in the period from 2008 to 2010.

For now, it likely will be better to bide your time instead of heeding the siren calls that multiply during the complacency of bull markets. Like Ulysses, dear investors, strap yourself to the mast and sail on.

Besides, don’t Canadians have enough debt already? According to credit agency Equifax Canada, consumer loans hit a record $1.422 trillion in the fourth quarter of 2014. Warnings about the debt loads of Canadians abound. Given this context, is it wise or sensible to urge Canadians to borrow more?

2 comments on “Why you shouldn’t borrow to invest right now: Larry MacDonald

  1. Nice to learn that I did something right
    I borrowed with a margin account in 2008-2009 but not more since

    Reply

  2. While most investors should not be using leverage, for those who do it’s important to make the decision for the right reasons. A lot of people can tell you all the stats for the US market but that’s not all we invest in. It is much harder to get similar measures for other markets which are likely (but not necessarily) at a different place.

    And whether or not other Canadians have enough debt already, I’m a little further than I need to be on the safe side even though I did borrow to invest this year. I’ll make decisions for myself, not based on what everyone else is doing.

    Reply

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