Mirror Mirror on the Wall - Does Margin Debt Predict Them All?

Recently, I was reading an article that was began discussing the record levels of margin debt on brokerage accounts. It made a deft point that record levels of margin debt “is a red flag that the market is over-inflated by speculation”. This is a bold statement; however, it is on the right path. Let’s take a deeper look into what they might have meant by that statement and what it may mean for today’s markets.

Since 1970, on a monthly basis the NYSE has been reporting the aggregate debits in securities margin accounts in which they kindly organized into tables and excel sheets. The chart below shows this data since 1996 plotted with the S&P 500 cash index.


As you can see in this chart, the margin debt (in $ mils) and the S&P 500 have a very closely related relationship. The record margin debt in February 2007 was $295,870; whereas the previous record was $278,530 in March of 2000. Is it a coincidence that the previous record was also at the peak of the dot-com bubble just before the markets began to crash? Maybe so, but I wouldn’t bet the farm on it.

The most logical reasoning/theory behind the close relationship (if you look at it, their activity almost mirrors each other) is that when the market is racing higher, market participants want in on the action and therefore leverage their brokerage accounts to take advantage of the rally. A high amount of margin debt also means there is a high level of bullishness. On the flipside, margin debts decrease as the market retreats due to a plethora of margin calls and participants having to get out of the way of an incoming steamroller.

Margin debt can be healthy during bull markets as it provides fuel for further market gains. The problem comes in when excessive speculation comes during a “false” bull market, which is where I believe we might be right now (the latest retest of the highs since Feb. 27th is a false rally in my opinion). The pitfall is when a steep decline in stock prices exposes investors to margin calls, requiring them to post additional collateral or sell securities resulting in even steeper declines such as February 27th, 2007. With so many questions in the marketplace; housing, inflation, interest rates, credit tightening, a weakening U.S. economy, trade deficits, budget deficits, weakening dollar, higher energy and commodity prices and equity markets at or near all-time highs, one has to wonder if a decrease in margin debt is necessary to bring the market to less prone levels.

At these levels, a doomsday may not necessarily be in the works, but it does make me wonder how long or how much higher both margin debt and equities can go. Since they mirror each other so closely, both of them are important to watch. At the same time there is a second voice in my head that tells me to be weary of false rallies in the market and to look for opportunities to hedge positions. As always, I hope you enjoyed the read and let’s see where the next few weeks take us. Tomorrow is the release of more inflation data (Produce Price Index) and it will be a market moving event. Which direction the market will go next is anyone’s guess. To paraphrase the JP Morgan, the only thing I know is that the market will oscillate with incoming data and news.

Sources: NYSE, eSignal