What Margin Levels Mean for Markets

stocks

Investors are constantly searching for ways to predict market behavior. They pour over any and all evidence looking for patterns and indicators that might help them spot opportunities or avoid costly mistakes. Some of these correlations are noted in lagging, current, or future economic indicators such as employment levels, GDP data, retail sales, and others. But there are few indicators that investors can look at to predict future crashes with any real degree of accuracy.

However, there is one oft-ignored piece of data that investors can use as a potential warning sign – the margin debt level. It tells investors how much leverage is currently being applied in the markets by calculating how much debt is being used in brokerage accounts. The more leverage that investors use, the riskier the position. If the market begins to decline, investors will scramble to sell as fast as possible to reduce the total amount of loss, often creating a panic resulting in large corrections or even a full recession.

Margin levels and market crashes

There’s a historical correlation between high margin debt levels and market crashes. One of the most famous is the the crash leading up to the Great Depression. Margin debt levels during the late 1920’s were largely blamed for the crash, with investors left exposed and struggling to cover their losses but unable to do so. During that time, margin requirements were as low as 10%, meaning investors could leverage up to $9 for every $1 invested. Contrast that with today’s margin requirements which average between 30% and 40%.

According to the NYSE, margin levels as of November 2017 are at record highs, with margin debt hitting more than $580 billion. If you track the performance of the S&P 500 and margin debt levels, you’ll see a strong positive correlation, which tells us that margin levels and stock performance seem to go together. This increased leverage helps accelerate buying on the way up and selling on the way down.

The real issue with higher margins is that as margin levels increase, so too must stock performances, in order to justify paying a greater amount of interest on loans. As debt grows, unrealistic market expectations and a disconnect from value begins to form, leading to dangerously volatile markets.

Final considerations

Much like stock market performance and P/E ratios, margin levels can remain high for years before actually correcting lower. While stock market peaks and high margin debt do go hand-in-hand, this isn’t a very efficient indicator. The market often continues to break through to new highs even during periods of high valuations or high debt levels, leaving investors who were on the sidelines missing out on huge gains.

The best way to handle increasing debt is simply to limit how much you apply to the markets and ensure that your positions are hedged, in case the worst case scenario happens. That way you still take advantage of all the upside opportunities without taking on excess risks to do so.