Margin Levels and What They Mean for Investors

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Investors have always looked for an edge in the marketplace. Any detail, no matter how small, is an advantage if it could predict future stock movements. Aside from the obvious, like economic data and stock returns, one element in particular carries a lot of weight when it comes to predicting stock market corrections and crashes: margins.

Trading activity can reveal a lot about the economy – in particular, how leverage and margin accounts are used. Investors with an appetite for risk use leveraged strategies to boost returns by borrowing money at a predetermined interest rate and using it to invest at a higher rate of return.

When margin is high, it generally means that investors have a large risk appetite and are bullish about the future. But it also means there’s far more volatility in the market and a lot more debt. Any slight downward correction when margins are high can mean dramatic declines or even crashes, as investors desperately seek to cover their loans by selling out of their positions.

How Margin Acts as a Prognosticator

 

Margin levels in the stock market have a long and storied history of being able to predict market crashes. Investment activity in the 1920’s leading up to the Great Depression was a classic example of how margin debt can harm the market. Some levered positions were as high as 10 to 1, which was of the biggest reasons why the markets crashed so quickly.

But the truly insidious thing about high margin debt is the inverse association of available credit to lend to borrowers. When margins begin to be called, financial institutions simply don’t have the money available to lend out to businesses and a shortage of credit is what really takes down the economy. Investors saw a similar problem play out in 2008 when the sub-prime mortgage crisis caused credit to dry up as real estate holdings were being foreclosed on and people could no longer afford their homes.

Interestingly, margin debt levels pointed to a crash before it happened, just like the Great Depression. From January 2007 to July 2007, NYSE margin debt levels rose 22% before finally peaking in August – a month before the sub-prime mortgage crisis hit the markets.

As of September, margin debt levels are over $501 billion – the second highest level recorded, with June of last year coming in at $507 billion. Margin debt has climbed 12% so far this year and seems to keep climbing, despite the risks. If history is any guide, investors should be wary of their stock holdings and be prepared for a runaway correction if the markets start to decline.

Correlation Doesn’t Equal Causation

 

While high margins have a high correlation with upcoming stock market crashes, it’s important to remember that correlation doesn’t equal causation. Margin levels have been high for the last several years without any major correction. In fact, margin levels have been around $450 billion and $500 billion for the past two years.

But there also hasn’t been a correction large enough to reach the tipping point that could ultimately send stocks into a downward spiral. The absence of a market crash despite high debt levels shouldn’t be a reason to dismiss the correlation. Right now, investors would be wise to tread carefully with any leveraged positions and be prepared to act quickly should the bull market turn into a bear market.