The sharp falls in many financial markets in late 2008 partly reflected forced position-closing by leveraged investors. Leverage levels now appear to be low by the standards of recent years, suggesting that future market moves will be driven more by “fundamentals”.
A measure of equity market leverage is margin debt outstanding on the New York Stock Exchange. This has fallen by 54% from a peak in July 2007, reaching its lowest level since August 2004 – see first chart below.
In the corporate bond market, deleveraging by market-makers with excessive inventory contributed to rapid price declines in late 2008. US primary dealers’ net long position in corporate securities is now the lowest since August 2003 – second chart.
Hedge fund leverage is difficult to measure directly but can be proxied by the sensitivity of their returns to market movements. The 30-day trailing betas of the FTSE "all strategies" and "directional equity" hedge fund indices to the FTSE World equity index are close to zero, suggesting little net market exposure – third chart.
As investors scrambled to close positions in late 2008, the Chicago Board Options Exchange implied volatility (VIX) index spiked to its highest level since the October 1987 stock market crash. Recent further equity declines were associated with a lower peak in volatility – fourth chart. A similar “non-confirmation” occurred at the October 2002 US stock market low, retested in March 2003.
