INVESTING: Weak markets could lead to a nasty surprise

If you open an account at a brokerage firm and deposit $100, you can sign a margin agreement and borrow enough money from that broker to buy $200 worth of stock. For years, market watchers analyzed the margin interest on the New York Stock Exchange-which measures how much stock people are buying using margin-as a reliable indicator of overbought or oversold conditions.

Things have changed today, though, and that could have a serious effect on your portfolio.

NYSE margin information was powerful because if a lot of investors were buying on margin, that meant the market was getting stretched on the upside and was due for a pullback. And the reverse worked during corrections. But now there are so many under-the-radar, uncountable ways to borrow money that we have no idea how much leverage is truly in the system.

I started thinking about this a few weeks ago when a story broke about a handful of funds in London that couldn’t meet the margin requirements for their copper positions. The fact they couldn’t meet their margin calls caused them to sell other stuff, namely equities. And that caused other margin calls, which caused more selling. This is known as the domino effect, and contrary to what our government officials tell us, we have no idea how far the chain goes.

A lot of esoteric borrowing gets done in the international derivatives market, and there have been attempts by some experts to measure total derivative exposure. But it’s impossible to know all the ways institutions borrow money to play securities markets.

Consider this: If you borrow money using a home-equity loan, then use all that money on the margin to buy a Rydex mutual fund with 2-to-1 exposure, you are leveraged 4-to-1-but only half of that is showing up as a margin purchase.

Imagine how easy it is for a “savvy” overseas institution to get hold of a few hundred million dollars, and how much trouble it can cause with that money.

All this leverage in search of higher returns creates systemic risk in the international financial markets. In 1994, the S&P 500 fell 1 percent, but the average stock fell almost 30 percent. The Brazilian stock market had to close for a day because one fund couldn’t meet a margin call. The rest of Latin America escaped a collapse by mere inches because one fund couldn’t pay back a debt. Leverage can make things ugly fast.

As you look around today and see that the major averages are only a few percentage points down from multiyear highs, you can be excused for thinking the water looks pretty good for a swim. You won’t find out how twisted and scary the situation is until after a major blowup occurs.

Right now, there is a bank or a fund that is leveraged way beyond any level of normalcy-most likely in emerging markets or metals-and the slightest hiccup is going to get the dominoes moving.

During strong bull markets, buyers are willing to step in to cushion the problem periods. But the markets are weak right now, which makes them susceptible to a nasty surprise.