I stumbled upon an interesting article over at Seeking Alpha yesterday, talking about margin debt and how its growth nicely correlates with the stock market in general. Let’s steal a small part of his work.
As you can see, the price of the S&P 500 and the level of margin debt have moved pretty much hand in hand throughout the whole chart. The author of the piece breaks it down even further, suggesting that most major stock market corrections were actually predicted by margin debt, which peaked a few months before the S&P started to decline.
Unfortunately, it’s not quite that simple.
Let’s talk a little about margin debt. Investors who are bullish on stocks but don’t have the cash to plunk down have a few choices. They can sit on the sidelines, but where’s the fun in that? They want action, dammit. They can borrow via short-term loans like from k24, but they tend to have high interest rates. They can borrow against their house, using something called the Smith Maneuver, which I’m going to go ahead and claim that I invented.
Or they can use margin debt, when they borrow from their stock broker.
By the way, if you don’t already have an online broker, use Questrade. Or, better yet, ditch your old one because right now they’re offering $250 in CASH MONEY BABY to switch.
Plus $4.95 per trade? I shouldn’t even have to beg you to sign up. Just go do it.
Anyhoo, there are certain rules that govern using margin debt from your stock broker. Depending on the price of the stock, you’re limited to approximately 150% of your total investments. It’s more complicated that that, but the details aren’t that important. If you have $10k invested, you can add another $5k.
What happens if you dip below that level? Great question. Have some frozen pizza. You get what’s called a margin call. Basically you either have to contribute more money to your account or sell some shares in something to get your level back to the acceptable level. If you don’t do it within a few days, your broker will automatically sell something for you. They ain’t screwing around.
When a bull market suddenly turns bearish, the unwinding of margin debt only makes the decline worse. This only makes sense, we’ve talked about how leverage can do this a million times. It’s great when times are good, and bad when things decline.
And there lies one of the problems. Using margin debt as an indicator is fine — in hindsight. But it’s really hard to use it as a predictive measure.
Why? Look at the chart again. The S&P 500 hit a record high over a year ago, in April, 2013. (I may have looked this up independently) Margin debt hit a record high shortly thereafter. And then proceeded to keep marching upwards. When margin debt is at a record, so is the stock market. Interest rates are as low as they’re going to get too, which could very well have an effect on how much people are borrowing.
What makes this margin debt call different?
Back to the original piece on Seeking Alpha, the author thinks he’s predicted the market top. The reason? Because margin debt actually peaked in February, and we’re now a few months later, just like most of the other declines. It’s an interesting theory, but only time will tell as to whether it’s right.
As for me? I’ve held shares in Revlon since 2007, buying at a (split adjusted) price of $11. The stock currently sits right around $33. I’m going to sell. I don’t have anything to put the cash into. I’m selling because I think now is a good time to take some money off the table. I may not fully agree with the peak in margin debt = market top, but everything else points to the fact it’s a market top.
I guess what I’m saying is that if you’re sitting on huge gains, now might be a good time to sell.