Do today’s record high margin debt levels predict a collapse?

My wife and I went to dinner with good friends recently. While it’s not typical dinner conversation, my friend mentioned his margin debt levels. He indicated that he needed a little extra cash right now and he didn’t want to sell any of his equity holdings. He told us that selling a few shares of his investments would result in a significant capital gain and tax burden. He elected to borrow against his holding via a margin loan instead. While this seems like interesting approach, the mere mention of margin debt brings a shiver down my spine. (More on my personal experience with margin debt later…)

Margin debt levels in the stock market recently reached an all-time high. Are such lofty debt levels reason for concern? Is this an indication that prices on the equities market are about to decline precipitously? Has the (over) extended eight-year long bull market run its course? Are we heading for a precipitous decline; a collapse similar to the declines in 2000 and 2008 when the major stock market indices fell by well more than 30 percent? The answer: it really depends on how the prognosticator interprets the tea leaves. Said differently: who knows; no one can predict the future.

What is margin debt?

Before discussing levels of margin debt, we need to understand what margin is. Typically when you buy stocks, mutual funds, exchange traded funds (ETFs), etc. you pay for those purchases with cash. If you were to buy 100 shares of Apple today, at $144 per share, you would pay your broker $14,400 plus a few dollars for brokerage commissions, as applicable. Purchases of equities can also be made with margin – borrowing money from your broker.

How much can I borrow?

The initial margin requirement for stocks is 50 percent. That means that if you paid your broker $14,400 for those 100 shares of Apple, your broker might be willing to loan you 50 percent of that – or $7,200 – to buy more equities. Simply stated, you can borrow half of what your account is worth. If you have $10,000 in cash and securities in your brokerage account, you can borrow $5,000. If you have $100,000 in your account, you can borrow $50,000. If you have one million dollars in your account, you can borrow $500,000, etc.

The money that you are borrowing doesn’t have to be used to buy more shares of Apple, although you could. That money can be used to buy more stocks, mutual funds, etc. The money that you are borrowing – and it is a loan – can be used to buy many other equities. Point of fact, the money doesn’t actually need to be used to buy stocks at all. The money is a loan from you broker. Like my friend did, you could take that money out of your brokerage account and use it for other purposes.

The borrowed money borrowed – be it for the purchase of equities or any other purpose – is subject to interest charges. The rate of interest is set by your broker and will adjust from time to time. The amount that you have an outstanding balance in your mortgage account – the money that you are borrowing – is subject to interest. Similar to an outstanding balance on your credit card, if you don’t pay off the entire amount that you are borrowing, you will have to pay interest to the lender, which in this case is your broker.

Margin calls

Provided that you meet the minimum requirements, you broker is happy to keep loaning you money and collecting the monthly interest payments. As the value of your equities increases, the more you can borrow. When you purchased those 100 shares of Apple at $144, you paid $14,400 and were able to borrow 50 percent of that, or $7,200, from your broker. As the value of your holdings increase, the amount you can borrow increases.

If Apple’s stock were to climb to $200 per share, your holdings would be worth $20,000. Your broker would still be willing to loan you half the value of your position, so in that instance, you could borrow a total of $10,000.

Keep it above 30

Is there ever a problem borrowing money from your broker? As long as the prices of your holdings remains: at or above the levels where you bought them, or even declines in value somewhat, your broker will be satisfied to simply continue collecting interest from you on the money that you borrow. The problem happens when the value of your portfolio declines. If it declines a lot, you might be subject to a margin call.

A margin call is one of the risks of borrowing money. While you are allowed to borrow up to 50 percent of the value of your assets, you need to maintain a reasonable debt-to-equity level. For most brokers, the breaking point is 30 percent.

Again, we will use the Apple example. If you had purchased 100 shares and $144 per share, and then borrowed 50 percent of the equity to buy more shares of Apple, you would have $7,200 in margin. If Apple’s stock price declines, the debt-to-equity level would decline as well.

If Apple’s stock price dropped to $130 per share, about a 10 percent decline, you would still be fine. There could be a problem if your portfolio’s value declines a lot. If the value of your holdings gets too low, your broker might demand that you come up with additional cash to return your portfolio to acceptable levels.

If the value of your holdings were to decline by 30 percent or more, your broker would likely issue a margin call demanding that you resolve the issue promptly. You can solve this by either adding new cash to your account or by selling a portion of your holdings. The goal here is to decrease your debt levels back down to acceptable levels.

Buy low, sell lower?

The idea of investing is to buy low and sell high. You want to invest today, hold your investments for a period of time, and then at some point in the future sell your investments, hopefully at a higher price thereby providing you with a profit. Buy low. Sell high. Margin calls negatively impact those plans.

Margin debt levels

image credit: Joe Lewis

If the value of your holdings decline to the point where your broker issues a margin call, you either have to add more money to your account or sell some shares. If you elect to sell shares, you will be selling when prices are low; presumably lower than the prices that you paid. Instead of buying low and selling high, you would be doing the opposite. The value of your portfolio starts to collapse.

Margin debt levels today

In February 2017, the total amount of money being borrowed on margin by investors hit an all-time high. The latest data from the New York Stock Exchange shows margin debt, or cash borrowed to buy shares, hit a record $528.2 billion in February, up from its prior high of $513.3 billion set the prior month in January.

Stock market values have been increasing of late. Starting in November, immediately after the presidential elections, through February, stock prices have been on a tear. The markets have expected that the new administration would be more business-friendly. As such, investors have bid up prices on most equities. Over than roughly 100 day time-frame, the S&P 500 index climbed by more than 10 percent.

As the value of equities increase, the amount that brokers will allow investors to borrow also increases. Some investors take advantage of this market euphoria and increase the amount that they borrow. Consequently, while stock prices have been increasing of late, the amount being borrowed on margin has increased as well, almost in lockstep.

Margin debt balances move with the markets

When stock market values increase, the amount being borrowed tends to increase as well. Conversely, as markets decline, the borrowing levels frequently decline as well. Oftentimes, you can see a direct correlation between margin levels and the values of the stock market’s indices. Markets rise, there’s a greater sense of optimism, there’s more money available to be borrowed, investors borrow more. Markets go up, margin debt goes up. Markets come down, so does the amount of debt.

image credit: dshort.com

Problems can arise when markets fall. If the market falls too quickly, many investors who borrow on margin will be hit with margin calls. While such calls can be satisfied by adding additional cash to those accounts, typically such calls are satisfied by selling shares of stock. If enough people are selling, the price of those shares will likely continue to decline thereby furthering the decline.

Look at the chart above. The dark shaded areas show recent major market corrections. The most recent such event, the financial and housing crisis took place between 2007 and 2009. The proliferation of financial instruments tied to home loans proved disastrous for the global financial sector as millions of American homeowners defaulted on homes they couldn’t afford.

Steep declines

Between October 9, 2007 and March 9, 2009, the Dow Industrials average declined from 14,164.53 to 6,547.05. That’s a 54 percent decline in value. This was the second-deepest and second-most-volatile (excepting 1987) bear market in the Dow’s history next to the one that began the Great Depression — a once-in-a-lifetime event for many investors.

The prior shaded area was the dot-com debacle. Irrational exuberance caused stock prices to reach unrealistic levels. Valuations on stocks were higher at this point than they had ever been in history. Numerous companies went public and went out of business between 1999 and 2000. The Dow price fell precipitously, losing 38 percent of its value, but losses on the tech heavy NASDAQ marketplace were far greater. On March 10, 2000 the NASDAQ peaked at 5,132.52 intraday before closing at 5,048.62. Afterwards, the NASDAQ fell as much as 78 percent. Again, losses were exacerbated by margin calls.

Rapid declines in the value of your holdings can trigger margin calls. When the markets fall by 78 percent, investors are being continually hit with margin calls by their brokers. Gains are augmented by investing on margin, losses are too. That 78 percent decline wiped out many investors.

Irrational exuberance, rapid decline… lesson learned

I got caught up in the market’s lofty valuations during the dot com era. I watched and listened to close friends boasting about the gains they were seeing in their portfolios; gains which were much greater than my own given my fairly conservative approach to investing prior to the dot com era.

My friends were making a killing by buying highly speculative tech stocks. But they were also “juicing” their returns by buying on margin. As stocks went up – seemingly by multiple percentage points every day – their portfolios went up even more since they were borrowing about 50 percent of the value of their holdings. As values increased, their buying power increased, so they keep buying more of these speculative tech stocks. They were making a killing. They were bragging. I wanted in. Big mistake.

By the time I joined the party – selling some of my safer holdings to buy these risker stocks – the bubble was about to burst. When it did, and I received a margin call, I not only to sell these tech stocks at priced well below what I had paid for them, I also had to sell some of my high quality holdings. I lost a considerable amount of money. I haven’t purchased anything with margin since then. Lesson learned.

It’s all different today?

It is easy to see the correlations between the declines during the dot com and financial markets and today’s markets. Equity prices climbed rapidly. Margin balances increased to (then) record levels as the stock prices climbed. When valuations fell, many investors were hit with margin calls, fueling the declining stock prices.

Will the same thing happen in 2017? Will stock prices fall as rapidly as they did during those two major bear markets? Will investors be hit with margin calls the way they were during those crises? Many can see the correlations and foretell gloom and doom; others are more optimistic and are reading the tea leaves differently.

Margin debt levels today are at 2.5 percent. That is, roughly 2.5 percent of the overall market capitalization for the markets is being borrowed. Is that high? Low? A margin level of 2.5 percent is pretty much in line with those levels back in 2013 about the halfway point of this eight-year bull market. Stock prices have continued to climb since then. Few seem to express concern over the current margin debt levels. The real concern happens when margin debt increases quickly and dramatically.

“Long bull markets such as this one tend to see margin expand steadily, recording many all-time highs along the way,” said Michael Shaoul, chairman and chief executive officer of Marketfield Asset Management, in a note to clients as reported by the Wall Street Journal. “Thus far usage of margin seems unexceptional.”

Only time will tell

Some fear that the markets have become overextended due to a protracted eight-year bull market and margin balances at record highs. Others believe that unlike earlier periods when markets were inflated well beyond any reasonable, rational expectations, values and margin debt levels today are reasonable and “unexceptional.”

Who is right? No one can accurately foretell the future. Market experts don’t know. Economists don’t know. Those who read tea leaves certainly don’t know. No one knows for sure. As Ben Graham once said, “In the financial markets, hindsight is forever 20/20, but foresight is legally blind.” Once time passes, we will know whether or not high levels of margin debt foretold a sizeable market decline.

I will leave you with a few more notable marketing timing quotes:

After nearly 50 years in this business, I do not know of anybody who has done it [timed the market] successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.
― John C. Bogle, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor

We have long felt that the only value of stock forecasters is to make fortune-tellers look good.
― Warren Buffett

What to do when the market goes down? Read the opinions of the investment gurus who are quoted in the Wall Street Journal. And, as you read, laugh. We all know that the pundits can’t predict short-term market movements. Yet there they are, desperately trying to sound intelligent when they really haven’t got a clue.
― Jonathan Clements

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