Investor margin debt returns to pre crisis levels

3 mins. to read

NYSE Margin Debt is a good indicator for the amount of leverage taken by retail (i.e. ‘unsophisticated’) investors. Accordingly, it tends to be a good predictor of market downturns (and upturns), as its peaks and troughs are usually seen as inversion points for the equity market – that is, troughs are a sign of an imminent bull market, whereas peaks are a sign of an impending sell-off.

The rationale behind this is straightforward: when margin debt is too high, investors are highly leveraged and so the likelihood of a margin calls surges as the smallest decline in asset prices can eventually result in forced liquidations and, ultimately, in a panic and a crash.

Whilst being a good indicator for leverage taken by retail investors, margin debt as an indicator does have its shortcomings though. Chief among them is the fact that ‘smart money’ has other ways of getting the leverage it needs, and rarely uses credit given by an exchange to finance trades. Hedge funds, for example, can either pledge collateral to prime brokers or engage in repurchase agreements with the same prime brokers (or other dealers). They basically don’t use conventional financing and thus NYSE margin debt is unable to capture the overall leverage of the market. Think of it as a similar situation to the ‘off balance sheet’ financing of the past.

So, while we can use NYSE margin debt as an indicator for overall market leverage, we should nonetheless take it with a pinch of salt. With that caveat in mind, margin debt is still a useful indicator however and excellent at indicating the level of euphoria in the market; which is usually connected with the disconnection between prices and fundamental value.

From the chart below, we can see that in February margin debt hit a record high of $465 billion. It then decreased a little until May when it was around $438 billion, but started increasing again in June and is now at $460 billion.

A peak in margin debt occurred in July 2007, three months before the equity market started to decline. At that point, Investor Net Worth (which is essentially Free Credit Cash Accounts plus Credit Balances in Margin Accounts less Margin Debt) was at a low (a negative value). Then the market crashed, and of course margin debt quickly decreased as investors deleveraged their positions. In February 2009, margin debt hit a nadir of around $173 billion.

But, with the Fed doing its best to seduce people to borrow money at near-zero interest rates, margin debt started rising again in 2009 while investor net worth decreased and went into negative territory from 2010 onwards. In particular, since July 2012, when margin debt was around $277 billion and investor net worth around -$14 billion, a new wave of euphoria took hold. Just two years later margin debt had surged to the current $460 billion while investor net worth plunged to a record low of -$182 billion.

The chart above clearly depicts the waves of investor euphoria, one happening before the financial crisis and the other currently unfolding. At this point, we are officially movinhg into unchartered territory, and although there is no pre-specified level at which we can say an reversion to mean will occur, we at least can tell that by historical standards the likelihood for margin calls is very high at this point, and which is more than enough to lead to a major crash once again.

With the Fed apparently close to winding-up its QE programme after a five year rally in equities, the market is out of fuel, and the retail investor is heavily overexposed. When the wave of margin calls begins, you don’t want to be around to see what happens next! Some believe, “not all margin calls come at once in the case of a sell-off”. Hopefully not for their sakes, but beware of herds and remember every avalanche starts with a solitary snowflake…

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