A Look At Margin Debt
Debt is as high as the bubble days, but cash is even higher.
This week, I want to touch on an indicator that has been abused by many bears for too long. It is something that has been around for decades, gets a lot of attention, and is almost always taken out of context.
We're talkin' 'bout margin debt.
WHAT IS IT?
Most brokerages allow customers to trade "on margin" by filling out and filing a suitability questionnaire that is scrutinized by management or compliance at the broker's office.
Back in the day, I used to manage the operations of a decent-sized discount brokerage firm, and one of my responsibilities was approving these applications. If a customer got my stamp of approval (note: dotting your i's with smiley faces does not help), then they were able to borrow money from us with assets in the account serving as collateral against the loan.
Most customers used their margin line to buy more stocks, but there was nothing preventing them from using the loan for other purposes, like throwing birthday parties for their wives in faraway places where the ice sculptures had wine flowing from…well, nevermind. Anyway, they got charged interest on the margin debt, just like any other loan, and we adjusted their margin rate on a sliding scale based on the balance they carried.
Because the loan is based on collateral that changes constantly in value (the stocks sitting in the account), there is a unique aspect to these loans called a margin call. If the stocks in your account fall in value and decline below the minimum equity limit imposed by regulators or the brokerage firm (which can be even more strict than the regulators' minimums), then they will notify you that you must take action immediately.
That action would involve selling some of the stocks in your account to pare down the margin balance, or you could wire them additional cash to shore up the asset side of your account. If the stocks keep falling, though, they're going to keep calling you.
When you sell stock in your account (not including short sales) and pay off your margin debt, you have what is called a free credit. These are funds that are available for you to withdraw at any time.
WHY SHOULD WE FOLLOW IT?
Because it's relatively easy to set up and use a margin account, watching these balances can prove to be a guide to the willingness of investors to speculate. If many investors decide to ride with Hoofy, they will borrow against their existing positions, buy more stocks, and overall margin balances will expand ever higher.
This is all fine and good – as long as stocks keep rising. When they don't, that's when the trouble can start. I had many a call passed to me from my margin clerks with irate customers on the other end when they didn't meet a margin call and we had to liquidate stocks in their account to maintain minimum equity requirements.
If stocks really fall hard, then margin clerks around the country (with panicky management standing over their shoulders) end up doing forced selling in customer accounts, exacerbating a market sell-off.
So we want to watch margin balance to see if
1) Investors are willing to take risk, and
2) If they're taking so much risk that it could lead to a systemic problem
But looking at the debt side of the ledger is inadequate. If we did that for most individuals or corporations, we'd conclude that they're careening into bankruptcy.
For a more accurate read on whether there may be real trouble ahead, we have to include free credit balances – the asset side of the ledger. Doing that allows us to see just how much leverage customers are taking on, and whether there is potential buying power available to fuel a market rise.
Margin information from the major exchanges is released monthly, and with a long delay at that, so this is not exactly day-trading material. Despite the lag, the data can still be used to determine if the overall market environment is healthy or at risk of possible trouble.
When you look at long-term balances, like GDP or many other economic series, all you see is a steadily trending line. To derive more meaning from it, analysts typically de-trend the data by looking at month-over-month or year-over-year changes. The same holds true for margin balances – watching the rate of change in the debt can be more useful than just plotting the debt itself.
WHAT'S IT SUGGESTING NOW?
A leading financial publication recently noted that margin debt was back to bubblicious proportions. Yep, it is, we can see that from the chart above.
But what about the cash? Not only is cash higher than it was at the top of the bubble, it is close to an all-time high. Look at the bottom pane of the chart – that's where we need to focus our attention.
Compare where those blue bars were in 2000 to where they were in 2002. Investors had a negative balance sheet to the tune of $128 billion in 2000 – that was fine as long as stocks kept rising, but when they began to fall and customers were getting margin calls, there was no extra cash to satisfy the brokers.
In September 2002, however, there was $50 billion more in free credits than there was in margin debt. When investors decided that they wanted to begin taking on risk again, and began paring down their cash levels and increasing their margin spending, stocks took off.
As of the latest data available, there is around $13 billion more margin debt than free credits at NYSE designated firms. There's nothing particularly notable about that figure, but I think the most important take-away is that this ain't 2000 (but it ain't 2002, either).
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