The use of margin debt to buy stocks is on the rise, and it is causing some market watchers to worry that the US stock market rally may be poised to come to an abrupt halt.
A high level of margin debt is seen as an indication of investor optimism about the stock market, but it is also seen as a sign that investors are becoming more speculative. Margin borrowing, like any kind of leverage, can magnify the returns on stocks when the market is rising. Investors typically borrow about 50% against the value of stock to be purchased. So it is not hard to imagine that, like all other kinds of leverage, margin borrowing will also magnify the losses of the inevitable market downswings.
Indeed, margin debt, or the amount investors are borrowing against their portfolios, has reached its highest level on the New York Stock Exchange since 2007, before the last stock market peak and subsequent crash. The increased borrowing is thought to be driven by rising stock valuations and low interest rates, but the worry is that if this debt is called the market could be in for a deep correction.
During the stock market run-up to the last two market peaks in March 2000 and October 2007, the level of margin borrowing was high, but it had been high for a long time. What changed in the months before the market peaked was the pace of change, in this case the acceleration, in the amount of borrowing.
And it is this rate of change that I consider a more important indicator of risk than the actual levels of margin debt. Today, the rate of change has not accelerated to an alarming degree. This margin indicator, one of many we look at, is not giving a signal that the end of this market run is near.
As I have said many times in the past, I prefer to look first at fundamentals and then at valuations. Technical and corollary indicators, such as the level of margin debt and its rate of change, are lower on my list of concerns.
At this time, fundamentals, such as cash flow, which supports earnings growth, are in good shape, albeit fading a bit. Valuations are within long-term bands considered normal. And technical indicators suggest temporary weakness, while the margin indicator is not near the warning levels that many seem to fear. In my view, red lights are not flashing, and the market looks to be trending higher. Stock mania has not yet taken hold; we remain watchful.
No forecasts can be guaranteed.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.