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Margin call!



The NYSE recently released its figures for margin debt for the month of May. This figure is obtained by accumulating the margin debit balances that customers owe NYSE member firms. Many of you are likely familiar with margin, but if not, in simplistic terms it allows one to borrow against equity (e.g. other stocks) in your brokerage account in order to buy more stock or take out money for miscellaneous purchases. As long as your stocks don't decline too much in value, you simply pay interest on your "loan" and everything is fine. However, when your stocks decline, you may get a margin call, meaning the broker is requiring you to put up more money - or sell some of your stocks - in order to keep the equity in your account at an acceptable level.

For the month ended in May, margin debt increased at the greatest pace since February 2000, at nearly 8% over what was seen in April. There have been no other month-to-month increases greater than 4% during the bear market. The next-highest increase, 4%, was seen in May 2001, which of course corresponded to the peak in equities that summer. This increase does tell us that investors are becoming more comfortable owning equities, and on the surface that appears to be bearish. After all, if traders are so optimistic about the stock market that they are borrowing against their holdings, isn't that a telling sign of complacency? Yes and no.

While it is true that this increase in optimism is a bit troubling considering we may still be in a very long-term bear market and there are a multitude of big-picture concerns, renewed investor confidence is necessary for rising prices. Traders buying stock on margin can provide a significant amount of fuel for further gains, unless and until the market begins to fall back again. And we've seen these investors pull in their horns to a tremendous degree over the past few years, as the chart below illustrates.

This chart shows the average margin debt over the past year compared to that over the past five years. As margin debt (the blue line) increases, it shows that investors are buying more and more on margin, compared to what they have done during the recent past. This isn't necessarily a bad thing, in fact it can be very, very good, unless it becomes extreme like it did before the crash in 1987 and the ultimate peak in 2000. However, there were several other periods when peaks in margin speculation did not necessarily lead to a declining market.

On the other hand, when investors have been stung my margin losses and brokers have liquidated a large amount of margined stock, the level of debt decreases and we see the ratio trough at a low level. This happened in 1970, 1975, 1982, 1991 In fact, we are currently seeing a record decline as far as this ratio is concerned. This is not terribly surprising since we also set a record on the upside only three years ago, but it is still notable. Also, I should note that the ratio has not yet turned up, but it is slowing its decline. If we have another increase in debit balances like we saw in May, then this ratio will finally have formed a low.

Over the past couple of months, we've seen some amazing displays of investor speculation that normally result in a down market, particularly when coupled with some of the other concerns that Toddo, John, Scott and Fleck have outlined. But we've also seen some encouraging signs that we may, just may, be seeing a market that could last for a while longer on the upside. I, like (too?) many others, am using the mid-June highs as a stopping point for short positions. I think there is too much speculation in this market to be healthy. But because of factors such as the margin figures, I have to respect the possibility that the bear may go into hibernation for the foreseeable future.

No positions in stocks mentioned.

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