What is margin debt? Why is it rocketing in 2021? And can the savvy investor use this knowledge to time future tops in the stock market?
Without a doubt, this data helps you get a better handle of wild speculation gripping Wall Street. But keep in mind that margin debt has its limits as a useful indicator of market psychology.
First, let’s define margin debt as simply the amount of money that investors borrow from their brokers to buy more stocks. In a cash-only account, margin doesn’t exist. Margin loans, which generate interest income for brokers on a daily basis, allow an investor to boost returns. But if the value of stocks or ETFs in an account on margin fall, the pain can intensify.
What Is Margin Debt, And How To Measure It
An account that is fully margined means an investor has tapped all available lending capacity to buy securities. Call it being 200% invested. Fully invested means all of the available cash has been used to go long, without using any margin.
Focus not on the total amount of margin loans being used to determine if investors are overly giddy, but on the year-over-year increase in total margin as reported by FINRA, the watchdog of the investment advisor industry. You can see FINRA’s monthly margin statistics at the group’s website.
IBD research has found four instances since the 1970s when the year-over-year change in total margin debt eclipsed 55% in a single month. In three of those times, the market had already gone on a supercharged run. Things had gotten overly frothy. At some point, Mr. Bear always arrives.
3 Major Stock Market Peaks
Margin debt explosion arrived near a major market top in these three instances:
- May 5, 1972: Margin debt up 55.8% year over year.
- Dec. 3, 1999: Margin debt up 58.9%.
- June 1, 2007: Margin debt up 67.5% (1).
A 55.4% jump on June 3, 1983, proved irrelevant. Stocks bottomed in August 1982. In the summer of 1983, the S&P 500 corrected 15% — well shy of a bear market drop of 20% or more.
After debt vaulted in May of 1972, the S&P 500 peaked seven months later in January 1973. The December 1999 figure came just three months before the end of the March 2000 dot-com bubble in the Nasdaq. The composite topped at 5132, then plunged 79% over the next 2-1/2 years. The June 2007 figure came four months ahead of the S&P 500’s then all-time high of 1576 in October that year.
In March of this year, margin debt spiked 71%. However, the severity of the coronavirus market crash may have skewed the amount of debt in March 2020. If debt levels stayed the same as in February last year, then the gain this past March would have been 51% — short of the 55% level.
So, huge increases in margin debt do not pinpoint the exact top. But they should encourage you to keep an eagle eye out for primary signs that the smartest institutions are racing for the exits. Focus on a rash of distribution days and vertical violations, which get covered in IBD’s signature market column, The Big Picture.
Dan Pipitone, co-founder of TradeZero America, notes that many of the firm’s new investors to the trading platform have converted cash accounts to margin. One reason: to start short selling.
“Additionally, TradeZero’s client base for the most part is flat overnight, meaning that the margin interest is not really used overnight, and we have not really witnessed a change in that,” Pipitone told IBD via an email exchange. This shows that margin is used in many ways, including day trading. “The use of margin intraday has greatly increased year over year, with intraday margin usage up over 75% this time last year on a per client basis,” he added.
YOU MIGHT ALSO LIKE: