Margin debt levels within the market are on a meteoric rise, with June 2021 finishing out at a record-high $882 Billion. [1] But such an intense rise in margin debt may not be much cause to celebrate; instead, history tells us that this trend may indicate an imminent market downturn.
Margin debt can be simply understood as debt taken on by an investor in order to extend their buying, and earning, power in the market. In essence, an investor borrows money to increase their initial investment and, hopefully, to supercharge their eventual profit.
For example, an investor might borrow $10,000 from their broker on margin in order to increase their initial investment from $20,000 to $30,000. If the shares they’ve purchased increase by 10%, the investor stands to make 50% more than they would have with only their own $20k.
Of course, taking on margin debt is also highly risky. When an investor’s balance falls below the minimum amount required by the broker, they may face a margin call. This margin call requires the investor to deposit more money or securities to maintain the broker’s minimum required value within the account.
Trading on margin is an attractive option when investors feel optimistic about the future of the security they’re investing in, or the overall market. However, this practice may have detrimental, rippling impacts within the market. Because borrowing on margin adds additional investment money into a particular stock or stocks, high levels of margin may actually begin to create a bubble. [2]
Excessive margin debt can be symptomatic of these speculative market bubbles, and eventual bursts, because it may signal overexuberant investor behavior, behavior that is not fully based in fact. As a result, several experts agree that exceedingly high levels of margin debt may signal an impending market drop.
In fact, sky-rocketing levels of margin debt have preceded both of this century’s extended economic downturns. Just before the dot-com bubble burst in 2000, margin debt was up more than 80%, and before the great recession in 2008, margin debt had risen by over 60%. [3] For context, margin debt is currently up more than 50% since this time last year and has risen 10.5% to date in 2021.
While high levels of margin debt are but one indicator of a potential market downturn, they are a critically important one to watch. In 2000 and in 2007, the S&P hit its own peak just a few months after margin debt peaked. Similarly, once margin debt hit its lowest point in 2009 following the recession, the S&P hit bottom just one month later. [4] The takeaway: the cyclical and relational nature of margin debt and overall market performance is not to be ignored.
The popularity of trading on margin has exploded, particularly in light of the newfound ease of doing so through popular app-based platforms like Robinhood. However, it is important for investors to keep in mind the broader market implications that an abundance of such trading may have, potentially in the near future.
Sources:
[1] https://www.finra.org/investors/learn-to-invest/advanced-investing/margin-statistics
[2] https://www.gobankingrates.com/money/economy/signs-of-market-bubble-crash-what-to-expect/
[3] https://www.fool.com/investing/2021/06/12/whos-ready-stock-market-crash-5-reasons-big-drop/