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Why Margin Debt Doesn't Matter


There is more than enough cash to offset margin calls


One of the favorite topics of those looking for a new bear market is margin debt.

In 2004, it was being used as a bearish crutch because it had risen so much over the past couple of years. In 2005, it was supposed to be bearish because it was getting "too high". In 2006, bears were excited because it was getting close to what was seen at the peak of the bubble.
Now, these guys are nearly beside themselves because margin debt is actually higher than what it was in March 2000.
Margin debt measures the dollars that brokerage firms lend to customers to buy whatever they wish, with securities held in the account used as collateral against the loan. The customer doesn't have to buy stocks – they can use the proceeds to fix up their house, take a vacation, buy a car, whatever – but usually the loan is used to "lever up" and buy more stock.
It would make sense to expect debt levels to drop as interest rates rise, but that's not the case. Over the past 50 years, there has actually been a negative correlation between changes in the broker call rate and margin debt, suggesting that investors are insensitive to rates – when they wanna buy stock, they buy stock.
Because these loans are typically used to leverage an account by adding equity exposure, watching margin debt levels is a popular way to measure investor sentiment. If people are expecting more of a market rise, they will tend to get more exposure via margin loans, and when this reaches fever pitch, this excessive optimism can spell trouble for equities.
But margin debt by itself doesn't tell us much. Comparing this debt to how much stocks are worth should give us more information, as it puts us on an apples-to-apples basis with historical readings. After all, a $1000 loan when you were in college probably seemed a lot more important than that same loan would today.
Well, even after adjusting for market capitalization, margin debt is still higher now than it was in the bubble years. Quite a bit higher, in fact (the scales in the bottom pane are multiplied by 10, so 18 is actually 1.8%).
But this argument is always missing an important ingredient. The NYSE doesn't just measure the debt that is owed by investors – they also monitor the cash (i.e. free credits) sitting in those accounts, too.
These cash balances do not include restricted cash that is generated by short sales, it only includes cash that is available for investors to withdraw. So let's take a look at those balances and see how they compare to the bubble years.
Incredibly, cash in these brokerage accounts is 100% higher than it was seven years ago. Customers have tremendous cash balances ready and waiting to be used for anything, including de-leveraging their accounts in times of duress, dampening the likelihood that we'll see mass hysteria from margin calls.
This cash could be coming from debt taken from other sources. For example, if a customer took out a home equity loan and put it into their brokerage account, it would show an increase in the free credit balances that the NYSE reports, even though the source of the funds is actually debt from another source.
I think this is a very small influence, however. I can't figure out why in the world investors would be paying 7% (or higher) interest on an outside loan in order to earn 1% (if even that) on cash sitting unused in a brokerage account.
Let's take one more look at the data, this time combining the two figures. We'll compute a "net worth" indicator which simply subtracts the debt from the cash. This should give us a bit of an idea of how much buying power is out there.
In 2000, this figure had dropped to its lowest level in 15 years. With the bear market taking hold over the next couple of years, the combination of shrinking market capitalization and rising cash balances ballooned this indicator to its most positive point in 50 years.
Market cap has been rising faster than this simple measure of net worth since then, driving the indicator lower. It's now negative, but it's nowhere near the extremes seen in 2000. In fact, it's still higher now than almost every month since 1950.
There are some valid reasons out there why we should be concerned about the possibility of a prolonged market decline.
This ain't one of 'em.
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