Stop Listening to Margin Debt Alarms

31 Oct 2013

Stop Listening to Margin Debt Alarms

Does a record margin debt level mean we are at the top of the market?  The short answer is no.

For several months I have been hearing more and more about margin debt levels, so thought it would be a good time to explain margin and why I do not believe it is a leading indicator of a market crash.

A margin loan allows you to borrow money using your investment portfolio as collateral for the loan.  You can use the borrowed money to invest more, or to withdraw the cash for other uses without having to sell investments in your account.  The lender will require you maintain a minimum loan-to-value ratio, which is the value of your loan divided by the value of your portfolio/collateral.

Why would you use a margin loan?  Some investors use it as a way to magnify their return.  Assume you invest $1,000 in an account and buy an investment that returns 10%, you make $100.  But if for that same $1,000 deposit you buy an additional $1,000 of that investment using a margin loan, then you have $2,000 invested and make $200.  Using the loan, you have magnified your return from 10% to 20% of the money you deposited in the account.  But beware, because a margin loan will also magnify a loss in the same way, so it can be a very risky strategy.

I rarely recommend using a margin loan as an investment strategy.  I believe it adds too much risk to a portfolio which usually does not fit with my clients’ objectives.  However, I often recommend it as a great way to obtain an easy and inexpensive short term loan.  I negotiate a good lending rate with the custodian/lender and there are no loan applications or processing fees.  The term is undefined, meaning you pay it back on your own timeframe and not at a preset date.  So there are actually very smart ways to use a margin loan.

Now lets look at the data everyone is talking so much about, NYSE Margin Debt, and compare it to the S&P 500.

Margin debt level compared to S&P 500

Margin debt level compared to S&P 500

Without a doubt, this chart illustrates that margin debt is correlated to the market (the two move together).  Past peaks in margin debt have occurred at the same time as market peaks.  This makes intuitive sense…

  • When the market goes up, investors can borrow more because the value of their portfolio is higher.  They also feel more confident about borrowing.
  • When the market goes down, investors sell to lower their margin debt and maintain their loan-to-value ratio.  They may also feel more insecure about carrying debt (and more risk) when the market is declining.

Does this mean that high margin debt is a leading indicator of a market crash?  No.  To be a leading indicator, margin debt would have to turn over (start to decline) before the market starts to decline.  We can see that the two move together, but not one before the other in a way that could “warn” us that the market is about to crash.

Record high margin debt is really just telling us what we already know  –  the market is at all-time high.  It is time we stop talking about market highs as if there is a magic ceiling.  We live in a world with inflation (albeit low at the moment), where we should expect the market to continually hit new highs.  We cannot call a “bubble” simply because the market has reached a level it has not reached before.

I suppose there is a magic ceiling for margin debt, and that is the loan-to-value ratio.  Different institutions have different requirements for different types of investments, typically 50% to 70%.  According to NYX Data, the current margin debt as a percent of total market capitalization is around 1.6%.  This is quite close to the long-term average, which has increased very slowly over the past few decades.

Thankfully others have started to debunk this margin debt myth.  Philosophical Economics writes a great post about it here with some very interesting charts.  Margin Debt: Move Along, Nothing to See Here

Even some main stream media (often prone to hysteria, doom, and gloom) have called for more rational thought, such as this WSJ commentary.

We will always have people trying to “call” a market crash and attempt to add validity to their argument through statistics.  Nobody has a crystal ball.  Sometimes someone is lucky, almost always they claim to be “early” (which is synonymous with “wrong” in my opinion).  Remember your time horizon and ignore the short term noise.

 

Comments are closed.