Stock market bubble: Red flag warning

TO GO WITH AFP SOTRY BY IDRISS ISSA A picture taken on June 16, 2011 on the Boucan-Canot beach in Saint-Gilles de la Reunion on the French Indian Ocean island of La Reunion, shows a red flag forbiding swiming because a shark alert. AFP PHTO / RICHARD BOUHET (Photo credit should read RICHARD BOUHET/AFP/Getty Images)


(MoneyWatch) Over the years, I've heard my share of questionable, dare I say stupid, investing comments. But one comment I heard recently stands head and shoulders above that crowd of stupid. In last Friday's Wall Street Journal, I read:

"This is not a warning that the markets are becoming frothy," said Jim McDonald, chief investment strategist at Northern Trust, whose firm manages more than $700 billion. "It makes sense in this environment to lever up and to take advantage of stronger returns."

Now it's not that Mr. McDonald is alone. The article included a graph of margined debt dating back to 1993. Margined debt is borrowing money from your brokerage firm to buy stock with the borrowed money, or levering to buy stock, as Mr. McDonald says makes sense. Margined debt has huge peaks and valleys and a new peak record has just been set. The previous peaks were in March of 2000 and July of 2007.

You may remember that the dates of the previous two peaks were just before two 50 percent plunges. As you and I would have predicted, the amount of margined debt was the lowest in 2002 and early 2009, just when it actually might have made sense.

Foolish as I thought it was to employ a buy high/sell low strategy, Mr. McDonald upped the foolishness factor by recommending that investors should borrow to buy even more stocks now that they are at an all-time high. And this is from someone with the title of "chief investment strategist" of a firm that manages $700 billion in assets. Given his position, I nominate Mr. McDonald's statement as the stupidest and most dangerous investment advice ever publicly made.

Levering to buy stock has nothing to do with investing and everything to do with extreme speculation. That's not to say that such a strategy couldn't work for awhile, as gambling isn't always a sure loser in the near term. It will not, however, work in the long run to build wealth.

Beyond McDonald's irrational exuberance, investors rediscovering borrowing on margin and hitting an all-time high is clearly a red flag warning that there may be a rip-tide. Be very careful before you swim too far from the beach and get sucked into it.

  • Allan Roth On Twitter»

    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.