NYSE margin debt levels hit a record in February, reaching $528 billion. For context this is 39% above the 2007 peak in NYSE margin debt. So what are the implications of record margin debt and does it hold any predictive power?
Margin debt refers to investors pledging their securities (i.e., stocks and bonds) to get a loan from their broker. The investors can use these loan proceeds for purchasing investments, or for other purposes. Rising margin debt is a signal of investor confidence, and increased borrowing against investments typically happens when stocks are rising and there is more value in investors’ portfolios for them to borrow against.
Plotting NYSE margin debt against the S&P 500 (adjusted to present-day dollars) reveals a close correlation between the two variables – as NYSE margin debt increases so does the S&P 500, and vice versa.
Source: Advisor Perspectives
However, correlation does not equal causation. It is tempting to jump to the following deductive conclusions:
- NYSE margin debt has peaked just before the last two recessions and stock market crashes – it appears to be a leading indicator of these events.
- We are now again at record levels of NYSE margin debt.
- Following on from NYSE being a leading indicator of recessions and stock market crashes, and with NYSE margin debt at a record level, we must therefore be due for another recession and market crash.
The above logic is convenient, but overly simplistic. It assumes that the past predictive power of NYSE margin debt will continue into the future and in all conditions. However, conditions have in fact changed, and dramatically so. Interest rates in the U.S. have fallen to historic lows since the Great Recession, and it is arguably easier to support these higher levels of debt. At the same time, margin debt has hit record highs a number of times since the post-recession bull market, with no corresponding market crash.
On the other hand, rising levels of margin debt increase the risks in the event of a market correction. Investors who borrow on margin must keep what’s called a minimum maintenance margin – that is, a minimum amount of equity held in the margin account. If there’s a decline in the value of stocks against which money is borrowed, investors may receive a margin call from their broker whereby they must post additional money into their margin account in a timely fashion. Failure to do so could result in their broker liquidating a portion of the shares to meet the minimum maintenance margin.
The issue with increasing levels of margin debt is that it can create forced, indiscriminate selling in the event of a market downturn. If the value of stocks declines by a sufficient amount, there may be margin calls, creating forced selling, which can create further margin calls. Rising levels of margin debt could also be particularly problematic if some investors are spending the proceeds from margin debt rather than purchasing investments.
While it is certainly not sufficient to use NYSE margin debt levels as a guide for market movements, it could be the case that higher amounts of margin debt may exacerbate any future market downturn. Wagers on the direction of markets are notoriously difficult to time correctly, although it is perhaps interesting to note that the Montaka team is finding it much easier to identify potential shorts in the current environment. That alone leads us to believe that caution should remain the order of the day.
Full credit to: GEORGE HADJA