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Can Margin Debt Give Us A Clue On Market Direction?

Written by admin | Mar, 28, 2013

margin-netcreditbalance-092811In times of uncertainty, when many fear the sky is falling and that there is no hope for recovery, a prudent investor will begin to look for opportunities.   The problem is getting the timing of those opportunities right.   Lately, there have been a raft of analysts and pundits promoting that the market is cheap and now is the time to be getting in. 

But is it?

We have written many articles about this subject from both the technical and the fundamental perspective.  Put simply the market is not cheap enough yet.  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.   During the 80’s investors used a modest amount of margin debt (borrowed money) to leverage their investments in the market.   As the internet boom launched online trading and turned the stock market into a giant casino margin debt exploded.  The speculative greed driving stocks higher was boosted by the addition of margin debt to unsustainable levels until the market peaked in 2000.  

As the market subsequently declined those same investors that were heavily indebted to broker-dealers for their margin lines were forced to liquidate.   As the markets declined forcing margin calls the additional liquidations drove the markets lower in turn forcing more margin calls and liquidations to occur.  This process continued even though each and every bounce on the way down led analysts and pundits to call a market bottom.  Late in 2002 and early in 2003, as many an investor had been wiped out and given up on the markets altogether, the markets finally bottomed.   By this point investors had gotten themselves back into a positive net credit balance in their margin accounts just in time for the Alan Greenspan to launch the next big bubble – real estate. 

As credit flooded the system due to lax restrictions and regulations the markets began to recover and move higher.  Investors, quickly remembered the boom years of the late 90’s and after having been decimated early in the decade were salivating at an opportunity to recover.   They quickly returned to the casino table to lever up their balance sheet drawing down on margin lines again all the while believing that this time they would know when to “sell”.  Margin debt obtained an all new peak heading into 2008 rising to more than $380 Billion.  Investors didn’t figure out when to “sell” this time around and the unwinding of that much debt spelled disaster for the financial system.   

margin-balance-vs-sp500-092811By the time the bottom of the decline was reached in March of 2009 positive net credit balances had ballooned to almost $200 Billion.  Surprisingly, after investors had been wiped out twice in a single decade they came storming back to the casino flush with cash as the Fed, due to the introduction of Quantitative Easing, removed investment risk, from the markets.  Investors scrambled to lever up their portfolios for a third time.    This time margin debt didn’t quite achieve its previous peak but quickly surged to $330 Billion.  We are now witnessing the third unwinding of leverage and the destruction of investor portfolios as a variety of risks run rampant through the markets.   However, can this unwinding of margin debt tell us anything about the market and where the next bottom, and buying opportunity, might be?

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. 

Currently, the recent decline has reduced the outstanding net credit margin balances to just a little over $4 Billion as of the end of August, however, we are still on the negative side.  Therefore, markets likely have further to go on the downside which will induce more unwinding of margin balances. The next bottom, 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.

While this is not a great “market timing” indicator, just like valuation levels, for investors; it is a good warning sign that we most likely have not reached the “fear” level necessary to denote a good 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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