by Lance Roberts
There has been much written as of late about the continued surges in margin debt. This was particularly the case when margin debt increased in January even as the markets declined. My friend Doug Short recently penned his monthly update on margin debt stating:
"The latest data puts margin debt at an all-time high, not only in nominal terms but also in real (inflation-adjusted) dollars. Here's a slightly closer look at the data, starting with 1995. Also, I've inverted the S&P 500 monthly closes and used markers to pinpoint the monthly close values."
"As I pointed out above, the NYSE margin debt data is several weeks old when it is published. Thus, even though it may in theory be a leading indicator, a major shift in margin debt isn't immediately evident. Nevertheless, we see that the troughs in the monthly net credit balance preceded peaks in the monthly S&P 500 closes by six months in 2000 and four months in 2007. The most recent S&P 500 correction greater than 10% was the 19.39% selloff in 2011 from April 29th to October 3rd. Investor Credit hit a negative extreme in March 2011."
Doug also correctly comments that:
"There are too few peak/trough episodes in ithis overlay series to take the latest credit-balance trough as a definitive warning for U.S. equities. But we'll want to keep an eye on this metric in the months ahead."
I too have previously discussed the rising levels of margin debt from this perspective. Therefore, in an attempt to answer these questions, we need to do two things:
1) Use a full set of margin data going back to 1959, and;
2) Apply technical analysis to the underlying data to determine if the momentum of increases in margin debt is reaching levels historically indicative of corrections in the markets.
For the second step, I will use two technical indicators: Stochastic Oscillator and Relative Strength Index. If you are unfamiliar with these indicators, here is a description of each via StockCharts:
"Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator "doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price." As such, bullish and bearish divergences in the Stochastic Oscillator can be used to foreshadow reversals. This was the first, and most important, signal that Lane identified. Lane also used this oscillator to identify bull and bear set-ups to anticipate a future reversal. Because the Stochastic Oscillator is range bound, is also useful for identifying overbought and oversold levels."
"Developed J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend."
In order to smooth the data of a 21-period Stochastic Oscillator, I have applied a 3-month moving average to the results. The oscillator, which ranges from ZERO (extreme oversold) to 100 (extreme overbought), is then overlaid against the S&P 500 Index (log base 2) for clarity. I have highlighted with the red bars whenever the oscillator hit the extreme of 100.
Historically, whenever this oscillator has reached extremes of 100, as it has currently, the markets have suffered either a mild correction or a sharp reversion. Shallow corrections occurred during cyclical bull markets, but unfortunately there was no real "warning" sign prior to a major market peak.
The next chart is a relative strength index of the changes in margin debt. The following is a 14-period (month) RSI with red bars indicating when levels reached extremes of 80 or above.
Once again, as with the stochastic oscillator above, when the RSI climbed to 80 or above, currently at 94.6, a correction in the markets generally followed soon thereafter. Again, the depth of that correction depended on whether the markets were in a cyclical uptrend or not. Also, as above, there is no identifier that denoted when a major market reversion had begun.
What both of these charts do suggest is that the current momentum of expansion in margin debt has reached historically important levels. It is likely that the markets will experience a correction at some point in the near future. What the data doesn't tell us is whether it will be a "buy the dip" opportunity or something much more significant. However, given the length of current economic expansion and cyclical bull market, the fact that the Fed is extracting liquidity from the markets, and the current extension of the markets above their long term moving averages, there is cause for real concern.
The current levels of margin debt are indicative of an extremely optimistic view of the market. What is important to remember is that margin debt "fuels" major market reversions as "margin calls" lead to increased selling pressure to meet required settlements. Unfortunately, since margin debt is a function of portfolio collateral, when the collateral is reduced it requires more forced selling to meet margin requirements. If the market declines further the problem becomes quickly exacerbated. This is one of the main reasons why the market reversions in 2001 and 2008 were so steep. The danger of high levels of margin debt, as we have currently, is that the right catalyst could ignite a selling panic.
The issue is not whether margin debt will matter, just "when." Unfortunately, for many unwitting investors, when that time comes margin debt will matter "a lot."
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