Margin debt still far from bottoming out for stocks

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Nailed the top last November and nailed the top and bottom since at least the 1990s.

By Wolf Richter for WOLF STREET.

Increases and decreases in leverage, when large enough, drive markets up or down. The only summary data on stock market leverage that we can obtain is the debt spread, reported monthly by FINRA, which obtains data from its member brokers. There is a lot more leverage in the market, but we don’t get a summary figure for it. Margin debt is our proxy for general stock market leverage.

The margin debt data that was released last November, for the month of October, was tops in the stock market, as margin debt had hit previous highs. More on that in a bit, including my long-term annotated chart. We are now looking for signs of a bottom. But as of the last margin debt release, we are far from bottoming out.

Margin debt fell by $24 billion in September from August, to $664 billion. But it is still very high, 39% above the low of March 2020. The falls in margin debt in January and February 2020 showed that there were already concerns that Covid could be destroying the markets, and some investors were prepared by reducing their leverage. At the current level, margin debt has much more room to fall, and the process can take years, as we’ll see in a moment, before it signals a bottom in the stock market.

From the chart above, you can see that the summer rally was doomed to be just another bear market rally because margin debt didn’t jump with it; it barely marked a little and then it disappeared.

Leverage is a huge factor in the direction of any market. Leverage is the big accelerator on the way up and down. Large spikes in margin debt invariably led to “events” in the stock market, and a bottom of margin debt preceded or closely followed the bottom of the sell-off.

The lower signal occurs when margin debt drops to lows from a few years earlier and then starts to rise again.

In the long-term view of margin debt, it is not the absolute dollar amounts that matter, but rather the sharp spikes in margin debt before liquidations and the declines beginning with liquidation and bottoming out at the end of the liquidation. liquidation. off.

The long-term margin debt chart below also shows stock market events. The debt spread will need to fall somewhere near a previous low set several years before the peak to signal a bottom.

The dotcom bust it started in mid-March 2000 (the Nasdaq Composite hit 5,048), which was also the month that the debt spread peaked. The debt spread bottomed out in October 2002, having fallen to a 1998 level, after the Nasdaq Composite plummeted 78%. Then they both began to rise again.

The financial crisis The drop was preceded by a large increase in margin debt to a high in July 2007. Then margin debt fell. The Nasdaq began falling on November 1, 2007, from 2,859, falling 55% to 1,268 in March 2009. Margin debt bottomed out in February 2009, reported in March 2009. The stock market bottomed out in March 2009.

As you can see, this process takes years, not months! The debt spread is not an indicator for day traders or short-term speculators who bet on daily highs and lows, but rather an indicator of longer-term trends.

Stock market leverage predicts stock market movements in a somewhat roundabout way: When the market begins a regular, mundane little sell-off, high leverage triggers selling episodes, usually of the most speculative stocks that have spiked higher. , and then are the first to sink: to pay the leverage to avoid margin calls, and trigger episodes of forced sale as the margin calls are going out. Leveraged investors have to sell stocks to pay off their margin debt, and this selling pushes prices further down, triggering more fire-selling and fire-selling fears, etc.

On the way up, increased margin debt increases buying pressure in the market, financed with borrowed money. And stock market bubbles need a lot of leverage to get there.

The debt spread is the big accelerator on the way up, as buying stocks with borrowed money creates new buying pressure that drives prices higher.

And conversely, margin debt is the big accelerator on the way down, as this borrowed money is taken out of the market by selling shares, just when new money is reluctant to enter the market to buy those shares at those prices, but is willing to buy those shares at lower prices. And the money taken out by marginalized investors then vanishes to pay off margin debt, instead of sitting on the sidelines somewhere.

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