Here’s some encouraging news for stock-market bears…
Margin debt (red in the chart above) hit a new high in April.
Even after adjusting for inflation, margin debt is now higher than it was at the peak of the great bull market in 2000 and the echo bull market in 2007.
What is “margin debt”?
It’s the amount of money stock investors have collectively borrowed via traditional margin accounts to fund stock purchases.
In a bull market, the growth of margin debt serves as a turbo-charger that helps drive stock prices higher.
As with a home mortgage, the more investors borrow, the more house or stock they can buy. So as margin debt grows, collective buying power grows. The borrowed money gets used to fund new stock purchases, which helps drives the prices of those stocks higher. The higher prices, in turn, allow traders to borrow more money to fund additional purchases. And so on.
It’s a self-reinforcing cycle.
The trouble is that it’s a self-reinforcing cycle on the way down, too.
When stock prices drop, which, eventually, they always do, borrowing capacity shrinks. And traders who maxed out their borrowing capacity are forced to sell stocks to meet “margin calls.” That selling often puts further pressure on stock prices, which then triggers more margin calls. And so on. So you get the same “turbo-charging” effect on the downside, which is one reason stock-market crashes can be so violent.
So where are we now?
Well, as these charts from stock-market-chart-maker-extraordinaire Doug Short at Advisor Perspectives show, we’re at the highest level in recent history.
Increasing margin borrowing (red line) has been turbo-charging the latest bull market (blue line) since the day it began in 2009, just the way it did in the 1990s and mid-2000s:
At some point — no one knows when — stocks will get hit. When they get hit, some of those who have borrowed money to buy them will have to come up with more cash to keep them, or they will be forced to sell them. This forced selling will likely accelerate the downward move. And that will trigger further margin calls and more forced sales. And so on.
There’s no telling when this will happen, just as there’s no way to definitively say when high margin debt is “too high.”
But the pattern is clear.
So don’t be surprised if the next “correction” seems a bit more sudden and violent than observable fundamentals might suggest it should be.