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An Update On Margin Debt

Written by admin | Mar, 29, 2012

margin-vs-sp500-032912We have written many articles in the past about market movements from both the technical and the fundamental perspective.  Lately there has been a raft of articles about the current cheapness of the market particularly after a 3 year bull market cycle.  The question is whether this is the case or not?

Warren Buffet once said “Be fearful when others are greedy; greedy when others are fearful.”   While I don’t agree with Buffet’s political viewpoints – his sage investment advice is priceless.  This bit of advice goes to the very core of the mistakes that investors repeatedly make.   The emotions of “greed” and “fear” have robbed more investors of their wealth than what has been lost at the point of a gun.

Investors, by and large, react emotionally to investing.   The average investor has the best of intentions of investing for the “long term” yet wind up doing the exact opposite of Buffet’s advice – they buy high and sell low.   This can be no more clearly shown than by the chart of margin debt and net credit balances.  As you can see in the chart – during the 80’s investors used a modest amount of margin debt (borrowed money) to leverage their investments in the market.  However, as the internet boom launched online trading, and ultimately turned the stock market into a giant casino, the use of margin debt has exploded.  The rise and fall of the S&P 500 is more closely associated today with the rise and fall of leverage than ever before. 

margin-balance-vs-sp500-032812

If we overlay the S&P 500 against the Margin Account Net Credit Balance (Free Cash and Credit Balances minus Margin Balance Outstanding) you can see that bottoms in the market occur when there are positive net credit balances.  Furthermore, bottoms in the market generally occur AFTER the peak occurs in the reduction of margin balances.

Today, margin debt is once again on the rise as the markets have moved higher since the lows of 2011.  With negative net credit balances already moving back towards lows associated with market tops; the “fuel” to spawn a significant rally from here is somewhat limited.  Market tops over the last couple of years have been found net credit balances have exceeded $50 Billion.  While the decline in 2011 reversed the outstanding negative net credit margin balances by the end of September – the subsequent rally has once again drawn that balance down sharply over the last few months.  By this measure stocks are not cheap by any means.  With net negative credit balances at roughly only 2/3rds of recent peaks, there is potential for the markets to advance from here, however, the risk/reward from this point is becoming much more limited.

As a side note – there have been many articles written about the “cash on the sidelines”.  However, the level of negative net cash balances speaks against that.  If there was a tremendous amount of excess cash in investment accounts there wouldn’t be negative credit balances.

The next great buying opportunity, if history serves as a guide, will not be until the reduction in margin debt peaks and begins to reverse.  At that point we can begin to more safely deploy capital as 1) the markets should be extremely oversold as liquidations have peaked; and 2) there will excess buying power due to lower margin debt and positive net credit balances.

Like valuation levels (P/E’s), margin level, is not accurate “market timing” indicator.  For investors, however, it is a good warning sign that we most likely are not at the “fear” levels necessary to denote a great buying opportunity.  Being patient and unemotional about investments are the two hardest things for an individual to do.  This is why there are so few successful investors in the world today that have survived the “long term” investing game.  Risk is a function of how much investors lose when they are wrong which brings us back to Warren Buffet and his two rules of investing: 1) never lose money and; 2) always refer to rule #1.

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