Margin debt is still far from calling a bottom for stocks

He nailed the peak last November and he nailed the highs and lows going back at least to the 1990s.

By Wolf Richter for WOLF STREET.

Increases and decreases in leverage, when large enough, drive the markets up or down. The only summary market leverage data we can obtain is margin debt, reported monthly by FINRA, which obtains the data from its member brokers. There is a lot more leverage in the market, but we don’t have a summary figure. Margin debt is our proxy for overall stock market leverage.

Margin debt data released last November, for the month of October, nailed to the top of the stock market, as margin debt had reached previous highs. More on that in a moment, including my annotated long-term chart. Now we are looking for signs of a bottom. But at the latest release of margin debt, we’re a long way from bottoming out.

Margin debt fell $24 billion in September from August, to $664 billion. But it remains very high, 39% above the low of March 2020. The declines in margin debt in January and February 2020 showed that there were already fears that Covid could tear markets apart, and some investors are prepared by reducing their leverage. At current levels, margin debt has a lot more room to drop – and the process can take years as we’ll see in a moment – ​​before it signals a stock market bottom.

In the chart above, you can see that the summer rally was bound to be just another bearish rally because margin debt did not jump with it; it barely ticked a little then fizzled.

Leverage is a huge factor in the direction of any market. Leverage is the great upward and downward accelerator. Sharp rises in margin debt have invariably led to market “events” and a trough in margin debt preceded or closely followed the trough in selling.

The lowest signal occurs when margin debt falls to the low of a few years ago and then starts to rise again.

In the long-term view of margin debt, it is not the absolute dollar amounts that matter, but the steep peaks in margin debt before sales and the declines that begin with the sale and bottom out at the end of the sale. stopped.

The long-term margin debt chart below also shows stock market events. Margin debt will need to fall somewhere near a previous low set several years before the peak in order to provide a bottom signal.

The Dotcom Bust began in mid-March 2000 (the Nasdaq Composite hit 5,048), which was also the month when the peak in margin debt peaked. Margin debt bottomed out in October 2002, after falling to 1998 levels, after the Nasdaq Composite plunged 78%. Then both began to rise again.

The financial crisis The crash was preceded by a huge spike in margin debt that peaked in July 2007. Then margin debt plummeted. The Nasdaq began falling November 1, 2007 from 2,859, plunging 55% to 1,268 in March 2009. Margin debt bottomed in February 2009, reported in March 2009. The stock market hit a trough in March 2009.

As you can see, this process takes years – not months! Margin debt is not an indicator for day traders or short-term speculators who bet on daily highs and lows, but an indicator of longer-term trends.

Stock market leverage predicts stock market movements in a somewhat indirect way: when the market begins a small, unremarkable regular selloff, high leverage triggers bouts of selling – typically the more speculative stocks that have the more increased, and which are then the most important. first to dive – to reduce leverage to avoid margin calls, and this triggers bouts of forced sale that margin calls come out. Leveraged investors have to sell stocks to pay off their margin debt, and that selling drives prices down further, triggering more forced selling, and more fear of forced selling, and so on.

On the upside, rising margin debt increases buying pressure in the market, funded by borrowed money. And stock market bubbles need a lot of leverage to get there.

Margin debt is the big accelerant to the upside, as buying stocks with borrowed money creates new buying pressure that pushes prices up.

And conversely, margin debt is the big downside accelerator, because that borrowed money is taken out of the market by selling stocks, just when new money is reluctant to enter the market to buy those stocks at these prices, but is prepared to buy these shares at lower prices. And the money that marginal investors took out then fades away into paying off debt on margin – instead of sitting on the sidelines somewhere.

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John A. Bogar