- High margin debt mostly tells us that investors are bullish on equities; there is no other reason investors would be using so much leverage to buy stock. A high proportion of bullish investors usually leads to slower future stock market appreciation as there is less fuel to drive prices higher.
- Beyond that, it is is difficult to make definitive conclusions on what high margin debt implies for equities looking ahead.
- Could margin debt rise further? Yes, it could continue to rise at the same rate as market capitalization and, objectively, not be out of proportion. But a dramatic increase, like in 2012-13, that turbo-charged the equity rally, is probably not likely.
- Could the stock market fall 10% or more? Yes, highs in margin debt have coincided with near term highs in the market. There's no need for margin debt to fall ahead of stock prices.
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The "margin debt" levels for the NYSE have received a lot of attention this week. In April, margin debt increased by 6.5% from March to $507b. This is a new all-time high in both nominal and inflation-adjusted (real) terms.
What is margin debt? Customers can borrow (cash) against the assets (stocks) in their brokerage account. Most often, this new cash is then used to buy more stock. High levels of margin debt means that investors are leveraged long, a sign that they are bullish equities.
So it should be no surprise that margin debt and equity prices move up and down together. As equity prices rise, customers have greater assets to borrow against, and using borrowed cash (leverage) to buy more stocks makes equity prices rise faster. That is what has happened in the past three bull markets (chart from Doug Short).
Of course, the reverse is also true: when equity prices fall, investors sell the stock they bought on margin; plus, the falling value of their collateral (stocks) helps to accelerate the trend downwards as investors are forced to reduce their margin debt (brokerages have the right to force the sale of stock in customers' accounts in order to cover the amount of their loan). That is what happened in the past two bear markets.
It should also be of no surprise that margin debt levels track investor sentiment. That investors today have assumed high levels of leverage in order to buy equities tells the same story as, for example, the Investor's Intelligence survey which indicates roughly 3.5 times as many bullish investors as bearish ones (read further here). That usually leads to lower future stock market returns as there is less fuel to drive prices higher.
Are current margin debt levels themselves too high? As a percentage of market cap, margin debt has only been slightly higher during two other months in the past 24 years.
What that implies for equities is hard to say: the first peak in margin debt in 2000 was a month before the stock market started a fall of 50%; the second peak in 2014 had no ill affect and equity prices are now 14% higher.
It's fair to say that there has not been a euphoric rise in margin debt this time as there was in both 2000 and 2007. Margin debt increased 75% and 68% into the two prior peaks; now in the past year, margin debt is up just 16%, about the same as the stock market.
In fact, a euphoric rise in margin debt now is unlikely. Why? Each of the two euphoric increases highlighted above started when margin debt was only 1.4% and 1.6% of market capitalization, respectively. The starting point now is 2.6%; in effect, the all-time high. A dramatic increase in margin debt, like the one in 2012-13 that turbo-charged the equity rally, is certainly possible but probably not likely.
That doesn't mean that the peak in equities is near. Margin debt could continue to rise at the same rate as market capitalization and, objectively, not be out of proportion. For that matter, 2.6% of market capitalization is not a magic number; perhaps it will rise further. There is too little history on which to base any assumptions that a higher level is not possible.
On the downside, it is certainly true that there is now sufficient leverage in the equity market that a reduction in margin debt would have a magnified impact on falling equity prices. In both 2000 and 2007, margin debt fell ahead of the peak in equities. Why?
In both cases, in the month that margin debt peaked, equities fell more than 10%. They then rose again over the following months to retest their former highs (arrows). But investors had already become spooked enough to reduce leverage. Tops aren't all exactly the same, but this is probably the trigger event that could lead to a larger than normal fall in equities with a concurrent drop in margin debt.
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