Analysts disagree about which indicator is best for calling market tops, but the easiest to understand – and the most tragic – is probably margin debt.
This is money borrowed by (usually individual or “retail”) investors against their existing stocks to buy more stocks. Investors tend to do this when markets are rising and using leverage seems like an effortless way turbocharge their gains. But eventually the market turns down, leaving stock portfolios insufficient to cover related margin debt and generating “margin calls” in which brokers demand more money and/or start liquidating customer portfolios.
This sends the market down sharply and indiscriminately, as fairly-valued babies are dumped along with overvalued bathwater. The result: a quick, brutal bear market.
Margin debt hit record highs several years ago and has just kept on going. From yesterday’s Wall Street Journal:
Investors’ Zeal to Buy Stocks With Debt Leaves Markets Vulnerable
Investors borrowing record sums to bet on stocks exacerbated this month’s selloff, after they were hit with calls to reduce those obligations and forced to sell shares to raise cash.
If that debt, known as margin loans, continues to rise at the current pace, analysts warn that big selloffs and sudden bouts of volatility in the stock market could become more commonplace.
Retail and institutional investors have borrowed a record $642.8 billion against their portfolios, according to the Financial Industry Regulatory Authority, as they try to pocket bigger gains by ramping up their exposure to stocks.
So-called net margin debt was worth 1.31% of the total value of the New York Stock Exchange last year, according to Goldman Sachs data stretching back to 1980, eclipsing the previous peak of 1.27% reached in the buildup to the tech bubble in 2000.
Lending against securities is a key profit center for brokerages, as firms charge interest on the money that is used and say they have found they better retain clients who take on the debt. These loans can also factor into brokers’ compensation, incentivizing many to extend money to clients regardless of whether they need it or not.
Margin debt has been on the rise for years and is generally considered a gauge of investor confidence. The long-running stock rally has helped push debt levels higher since investors tend to be more willing to take loans against investments that are rising in value. However, it can also precipitate a steep market downturn as it did before the burst of the dot-com bubble and the financial crisis of 2008.
The growing loan balances have caught the attention of Wall Street’s watchdog. Finra in January published an investor alert after the total value of margin loans broke $600 billion for the first time, saying investors may be underestimating the risks of trading on margin and may not understand how margin calls work.
Many of the hardest-hit investors were those who had used exchange-traded products to wager that low volatility would persist and stock prices would remain stable.
Harvey Hajiyan, a 35-year-old financial adviser who lives in Toronto and has been investing for more than a decade, assumed stocks would continue to grind higher this year, similar to the gains the Dow and the S&P 500 had posted for much of the past two years without a pullback.
“All of the strategists agreed the market would go up,” said Mr. Hajiyan.
At the end of January, he placed an ill-timed bet and used only margin to fund a large position in the ProShares Short VIX Short-Term Futures exchange-traded fund (SVXY), which rises as long as stock prices remain stable. When the S&P 500 fell into correction territory to erase one of its best starts in years, Mr. Hajiyan’s investment in the ProShares fund tracking expected market swings was nearly wiped out, forcing him to liquidate hundreds of thousands of dollars of securities to answer the margin call.
“I was in denial,” said Mr. Hajiyan after he realized he lost about 600,000 Canadian dollars (US$472,260) worth of his C$1.1 million investment portfolio.
Despite losing a sizable portion of his wealth, Mr. Hajiyan says the experience hasn’t soured him on using margin debt. “If I wasn’t using margin, I wouldn’t be at this level,” Mr. Hajiyan said of his profits before the pullback. “As my money grows, I’ll limit the amount of margin I use.”
