NYSE Margin Debt: Spooky Scary or just another number?

The financial world is abuzz lately, attempting to decipher what exactly record levels of NYSE margin debt means for the future of the stock market rally. The numbers are a little scary at first glance, with the amount of money borrowed from stock accounts (usually to buy more stock with the borrowed funds, thereby adding leverage to their accounts) moving up to $400 Billion, and over 2.25% of United States GDP. See below from the blog Value Walk:

Margin Debt

Charts Courtesy: Value Walk
(Disclaimer: Past performance is not necessarily indicative of future results)

The scary part about those numbers is that the last time they were this high (at least on the percentage of GDP scale) was in 2000 and 2007, which for those who can remember a time before the stock market just went straight up – were the peaks preceding some rather nasty downturns in the stock market. Here’s the performance of the S&P 500 in the period after margin debt first reached 2.25% of GDP previously:

Sp 500 Margin Performance
Source: Value Walk
(Disclaimer: Past performance is not necessarily indicative of future results)

Why does margin debt precede market meltdowns?  Well – for one it is a signal of over-confidence in the market – which is usually a contrarian indicator, but the bigger issue is that borrowing has the little issue of needing to be paid back… Arabian Money provides a rather simple explanation:

“…margin debt works in both directions. It accelerates the upside in stocks by allowing punters to buy with borrowed money but then it accelerates the drop in a stock market by taking it away from them. How does it do that? Well think about it. If you owe money then you will be forced to sell a perfectly good asset in a falling market to pay off your debt, and that sale accelerates the fall in stock prices.”

Basically, when you borrow to buy stocks, and those stocks go down – you are forced to sell to pay back what you borrowed.  The larger amount of borrowed money there is, the larger the amount of forced selling on the way down.

But not everybody is so sure this means doom and gloom – the Reformed Broker points us to the Philosophical Economics Blog as proof that this is just the latest bogeyman propped up by bears to send false warnings. His argument essentially boils down to the fact that margin debt rises as the market rises, and will usually if not always be at record highs when the market is at record highs. He points to August of 1983 as an example where margin debt and stock prices were at all time highs, right before the market had one of the greatest bull runs in history counter proof (conveniently leaving off the internet bubble burst from the chart).

SP 500 up to 2000
Chart Courtesy: Philosophical Economics Blog
(Disclaimer: Past performance is not necessarily indicative of future results)

So where are we now? Are we in 1983, or back in 2007? Are we about to enter an even larger bull market, or see prices fall 50% or more? There sure is a lot different in the world today than in 1983, or even 2007 for that matter. And the moral of the story is a single indicator like this doesn’t tell the whole story. Use it as a data point, sure. But realize it is just that, a single data point to be considered with all the others – earnings growth, valuations, GDP, the Fed and more.  It’s a lot to take in, making us thankful that those in managed futures don’t have to always worry about this sort of thing, as a freak blizzard last month pointed out.

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