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Margin Debt: The Next All-Time High?

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What margin debt is, and why it's so significant.

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As a partial answer, there is an indisputable positive correlation between the growth and contraction of margin debt and broad-based market performance. As you might expect, the value of stocks held and the amount borrowed to hold them necessarily goes up and down as the market does. But whether margin debt's rate of growth and/or absolute level has a causal link to market tops and bottoms is more controversial and difficult to demonstrate.

The goal here is more modest: to review what margin debt is and see if it has any pressing relevance today.

As I mentioned earlier, the middle and right columns in the graphs above are very helpful for providing context and "anchoring" margin debt so we can speak about whether the current level of borrowing is modest, moderate, or excessive.

So where are we?

Again, March 2013′s figures show "the market" as a whole is in the hole some $380 billion. Over on the positive side of the ledger (middle/right columns above), cash and credit come to $287.3 billion. The result: the market has a negative net worth of -$92.2 billion.

Looking beyond raw margin debt, this net worth figure far exceeds the June 2007 high of -79 billion. However, it isn't a record. As the following chart published in March (pulling from January 2013′s figures) by Doug Short shows, at its height the dot-com bubble featured aggregate negative net worth exceeding -$100 billion for multiple months.



So it's not a record. But keep in mind: Early 2000's aggregate net worth figures are what drove the Nasdaq to 5132, a speculative peak from to which it is only beginning to appreciably recover 13 years later. Perhaps 2007′s net worth figures are more instructive, but if so, that lends little comfort. Negative net money doesn't necessarily indicate a market top, but negative net money blow-offs (February 2000, June 2007, even spring 2011) do appear to precede market tops. Are we witnessing just such an occurrence right now? With the impact of inflation, market cap growth, and the not-so-invisible hand of the Fed, the picture has never been muddier. Let's just say the "excessive" conditions that prevailed in pre-QE world are here once again. The environment is different, but history may rhyme, despite those forces arrayed against that outcome.

The key to understanding this is the concept of "adversity tolerance," i.e. the degree of stress the aggregate market's balance sheet can take. If history is any guide, according to aggregate margin debt and net worth right now, "the market" is confident – highly confident. But like any bout of confidence and bull market built on rising levels of debt, the instrument of the market's growing confidence ironically sows the seeds of its own undoing.

If stock indices do take a sizable turn south, judged in historical terms the depth of the market's negative net worth means it has very little tolerance for that kind of adversity. In practical terms, this means there's little margin for error (read: selling); and little room to maneuver before margin calls occur and forced selling is required. This activity creates a downdraft that can spin a healthy pullback into a more significant correction, if not a protracted bear market. In fact, the amount of margin debt taken on ahead of these downturns demonstrates a behavioral pattern where the aggregate market is either entirely oblivious to what lay ahead or radically underestimates the depth and extent of the adverse move it will have to weather.

Market timing with sentiment measures is a very difficult business, but as a contrarian read on the environment, polls and stats like margin debt and net worth can be invaluable inputs to a process that makes more quantitative assessments of risk. Right now, the confidence reflected in that input – its own emerging bubble in certainty – counsels heightened caution.

This article by Andrew Kassen was originally published on See It Market.
No positions in stocks mentioned.
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