March 28, 2023

Marginal debt is still far from the fact that stocks have no bottom

It nailed the top last November, and it’s been nailing tops and bottoms since at least the 1990s.

By Wolf Richter for WOLF STREET.

The increase and decrease in leverage, when it is large enough, drives the market up or down. The only summary data on stock market leverage we can get is margin debt, which FINRA reports monthly from its member brokers. There is a lot more leverage in the market, but we don’t get a summary of that. Marginal debt is our stand-in for general stock market leverage.

The marginal debt data from October, published last November, nailed the stock market to the top, because the margin debt had previously peaked. More on that in a bit, including my annotated long-term chart. Now let’s look for bottom marks. But according to the latest publication on margin debt, we are far from the bottom.

Marginal debt decreased by $24 billion in September from August to $664 billion. But it remains very high, 39 percent above the March 2020 low. The decline in margin debt in January and February 2020 showed that there were already concerns that Covid could tear up the market, and some investors were preparing to reduce their leverage. At current levels, margin debt has a lot more room to fall—and the process could take years, as we’ll see in a moment—before it marks the bottom of the stock market.

In the chart above, you can see that the summer rally was doomed to be another bear market rally because margin debt didn’t jump with it; it barely ticked a little and then boiled over.

Leverage is a huge factor in the direction of any market. Leverage is a great accelerator on the way up and down. Large spikes in margin debt invariably led to stock market “events,” and bottoming in margin debt either preceded or closely followed selling bottoms.

A bottom signal occurs when the marginal debt falls to its lowest level in a few years and then starts to rise again.

In the long-term view of margin debt, it’s not the absolute dollar amounts that matter, but the sharp spikes in margin debt before the sale and the declines that start with the sale and bottom out at the end of the sale. skew.

The long-term margin debt chart below also shows stock market events. Marginal debt needs to fall somewhere near the previous low established several years before the spike to signal a bottom.

Bust of Dotcom began in mid-March 2000 (Nasdaq Composite reached 5,048), when the spike in margin debt also reached its peak. In October 2002, marginal debt fell to 1998 levels after the Nasdaq Composite had fallen 78 percent. Then both started to rise again.

Financial crisis the collapse was preceded by a huge spike in marginal debt to a peak in July 2007. Then marginal debt fell. The Nasdaq started falling from 2,859 on Nov 1, 2007 and fell 55% to 1,268 in Mar 2009. Margin debt bottomed in Feb 2009, reported in Mar 2009. Stocks bottomed in Mar 2009.

As you can see, this process takes years – not months! Margin debt is not an indicator for day traders or short-term speculators who rely on daily ups and downs, but an indicator of long-term trends.

Stock market leverage predicts stock market movements in a somewhat indirect way: When the market begins its daily regular small selling, high leverage triggers selling bouts—usually the most speculative stocks that rose the most and are then the first to plunge—pay down leverage to avoid margin calls, and that triggers bouts of forced sale when margin calls are running out. Leveraged investors have to sell stocks to pay off their margin debt, and this selling pushes prices down further, triggering more forced selling and increasing the fear of forced selling, etc.

Growing margin debt increases the market’s buying pressure in the market financed with loan money. And stock market bubbles need a lot of leverage to get there.

Marginal debt is a big accelerator on the way to the rise, because buying stocks with borrowed money creates new buying pressures that raise prices.

And conversely, margin debt is a big accelerator on the way down as this borrowed money is pulled out of the market by selling stocks just when new money doesn’t want to come into the market to buy stocks at those prices, but is willing to buy those stocks at a lower price. And the money that the margin investors took out then disappears to pay off the margin debt – instead of being “on the sidelines” somewhere.

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