I had an interesting conversation the other day with a friend of mine who asked a very compelling question: with margin debt in the equities market hitting a new all-time high—$401 billion on the NYSE in September—is this a sign of a market top?
To find out what this really means, we have to dig a little deeper into how this can affect the equities market.
An increase in margin debt is really a story of investor sentiment. As the equities market moves up, this gives people more confidence and therefore increases investor sentiment. Many investors then borrow money to invest in the seemingly bullish market—this creates margin debt.
Now, this all sounds great on the way up, but in the end, the problem with higher levels of margin debt is twofold.
First, the very fact margin debt is increasing can be looked at from various angles. One is the obvious point of view that investor sentiment is becoming increasingly bullish on the equities market, so people are borrowing to get in on the action.
Another way to look at higher levels of margin debt is that while borrowing money to put into the equities market is bullish, as more money is chasing the same number of shares, at some point, if everyone is in the market, who’s left to buy?
Second, the real problem with high levels of margin debt is not on the way up, but when the equities market begins to turn. While investor sentiment can shift rapidly, the problem with investing on borrowed money is that it becomes far more painful on the way down.
This could lead to exaggerated moves to the downside. Borrowing to invest (and doing so at record levels) is like pouring gasoline on a fire. Sure, it can increase the size of the fire, but it becomes much more dangerous and could easily spread out of your control.
So when the market begins to turn, investor sentiment begins to shift away from optimism, which initially causes some selling pressure. But because this is based on borrowed money, this snowballs into even heavier selling pressure in the equities market.
Essentially, higher margin debt means the risks to the downside are increasing. While the equities market doesn’t necessarily have to sell off tomorrow, when it does happen, a higher level of borrowing will mean a faster descent.
This record level of margin debt is indeed a warning sign. Because the equities market has been pushed up by this additional flow of funds, any sign that investor sentiment is shifting will lead to a pullback in margin debt, and this leads to selling pressure in the equities market.
If these investors had adequate capital, they wouldn’t be borrowing money to put in the equities market. So when we see data showing a pullback among the investors who are the most leveraged, this will lead to large selling pressure.
But because the equities market is at such high levels with a record margin debt, this combination along with the shift in investor sentiment could lead to a significant and dramatic sell-off.
While timing the market is impossible from simply looking at margin debt, it is an additional warning sign. The record level of margin debt is an indication to me that we are closer to the end of this run in the equities market than the beginning.
Investors need to be aware of any shifts in investor sentiment and adjust their investments accordingly. The trigger I’m watching for is a decline in margin debt.
This article Stock Market Warning: Margin Debt Hits Record-High $401 Billion was originally published at Investment Contrarians