A man must be big enough to admit his mistakes, smart enough to profit from them, and strong enough to correct them. - John C. Maxwell
I was wrong. There, I said it.
Over the past few years many market technicians (including myself) were looking at the continuously increasing new highs in margin debt as a warning sign stocks were topping. In retrospect and having a different perspective I have concluded we were wrong.
There is no arguing, margin is fuel to the bull market fire. For those not aware, when investors/speculators run out of their own money to invest, they can borrow from their brokerage institutions against a portion of their brokerage account. As long as they can make more money than the costs to borrow it can make sense to use margin. The times it becomes a problem is when those same investors/speculators have 1) reached their borrowing limit or 2) if stocks decline. If investors have no more money to invest (whether from their own sources of funds or borrowed on margin), the market runs out of buyers and can go no higher. If stocks decline margin investors are forced to sell positions to pay off the outstanding margin debt which is being demanded from their broker. Since they have no remaining liquid funds (all funds are fully invested) this forced liquidation adds more sellers which of course, drives the market down even further. And on it goes, potentially snowballing. Where the level of margin debt really matters is that the greater the margin debt, the greater the possible decline.
Back to being wrong … My view had always been because margin debt reached a new high it could not go higher and so stocks had to decline. As it turns out that thinking was completely wrong and where I should have focused my concern was not at whether it was making new highs (because that is actually very bullish) but rather if margin debt CHANGES DIRECTION and starts to decline. Going higher has the effect of pushing prices higher, falling margin has just the opposite effect. It seems so simple now, what the heck was I thinking?
This leads me to this week’s chart which is that of a historical look back at margin debt updated through the first quarter of this year. The red line is the US Stock market (SP500) and the blue line is margin debt. What I would hope you take away from this chart is at least the following
1) Rising margin debt = rising stock prices
2) Falling margin debt = falling stock prices
3) Peaks in margin debt have coincided with peaks in the stock market
4) Margin debt peaks first
Now you have that firmly ensconced in your brain, ask yourself this, “is the decline in margin debt from the start of this year a temporary blip or the start of a new trend?” Don’t know the answer? Me either but I do know this, it is not the time to be attempting to be a hero and taking on excessive risk.
