Margin Momentum ... Or Mayhem

The U.S. stock market’s march to record highs has been accompanied by surging margin debt, a potential red flag for investors.

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Anyone who’s been close enough to the stage at a rock concert to make out the tattoos on the lead guitarist’s forearms is probably familiar with the noise: an eardrum-splitting, cringe-inducing SCREEEECH! It’s sound circulating out the speakers, back through the microphones, and around again in kind of a sonic death spiral, over and over. Effect returning to cause, and so on. The feedback loop. Maybe not as excruciating as yet another call for “Free Bird,” but still: not pleasant.

Think of trading stock on margin in similar terms. If your portfolio features an arena-ready “lineup,” an astute manager, and a good “mixer,” chances are you’ll probably be fine. But taken to extremes, margin can turn into a feedback loop and take a portfolio down the drain.

Many traders use margin to boost the size of investments and amplify gains in an ascending market, driving demand for stocks higher and adding additional fuel to a bull run. But it can also work the opposite way. What happens when margin gets too high? Sometimes, mayhem.

Irrational Borrowing, Irrational Exuberance?

Looking back over the last two decades, margin debt typically followed the broader U.S. market. As the Standard & Poor’s 500 index climbed, so did margin debt. It’s important to note that although there appears to be a correlation, it doesn’t necessarily mean that high margin is an immediate harbinger of a bear market.

However, a closer look reveals that the rate of margin growth could be cause for concern. In the late 1990s, a spike in margin debt for NYSE-traded stocks spiked to what was then a record. Shortly after, the tech bubble burst and markets went into a protracted nosedive.

In another example, margin surged in 2007 as the broader market was nearing a top and the economy was tipping into recession (see figure 1). One might interpret these margin spikes as a sign of the “irrational exuberance” that often preceded a market turn, though it’s important to weigh other factors, such as overheated prices for real estate or technology shares.

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FIGURE 1: ON THE MARGIN. In recent history, a downturn in margin debt (blue line) coincided with a slump in the broader U.S. market (red). Source: Investools. For illustrative purposes only.

Now, notice how margin declined before stocks did in the previous two tops, which were both followed by bear markets. As prices fell, stocks used for margin collateral lost value. This resulted in an increase of margin calls and the selling of more stocks for losses. Again, the feedback loop.

Similarly, as investors start to close out of their margin trades, increased selling pressure can push stock prices down (remember, every seller must find a buyer at some point). The selling of shares and the shrinking of collateral creates a negative feedback loop that pushes stocks lower. This is why particularly high margin debt is a concern. The more trades that need to be unwound, the longer the feedback loop can be.

Altitude Sickness

This year, the S&P 500 and the Dow have generated a semi-regular parade of all-time highs, and sure enough, margin debt surged as well. In September, margin debt among New York Stock Exchange members reached $463.9 billion, up 16% from the same month in 2013 and the third-highest on monthly total on record, next to $465.7 billion in February and $464.3 billion in June, according to NYSE data.

By comparison, in August 2007, margin debt was $331.4 billion, up 46% from a year earlier. A few months later, the S&P 500 slipped into a bear market and the Great Recession was underway.

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FIGURE 2: ON MARGIN. Go to Balances & Positions under the My Account tab after logging in to tdameritrade.com for updated figures on margin equity, maintenance requirements (yellow arrows) and other related numbers. Source: TD Ameritrade. For illustrative purposes only.

Have we reached another point of irrational exuberance? Time will tell, and granted, current circumstances are much different than seven years ago. Still, there are a lot of trades that would need to be unwound if the market turns south. This is not to say margin patterns are necessarily a leading indicator for the overall market. But for investors, it’s worth watching and should be considered against the big picture.

We don’t intend to put a black hat on margin. Margin can increase an investor’s effective returns, if applied with discipline and caution. But it can also bankrupt you, and we fixate on that for good reason. Make sure you understand how it all works, and regularly monitor your accounts if you have margin balances.

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Margin trading increases risk of loss and includes the possibility of a forced sale if account equity drops below required levels. Margin is not available in all account types. Margin trading privileges subject to TD Ameritrade review and approval. Carefully review the Margin Handbook and Margin Disclosure Document for more details.

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Investools, Inc. and TD Ameritrade, Inc. are separate but affiliated companies that are not responsible for each other’s services or policies. Ryan Campbell is not a representative of TD Ameritrade, Inc. and his opinion and commentary should not be construed as an endorsement or recommendation of TD Ameritrade, Inc.

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