Margin Debt Surges as Bulls Leverage Bets

In the newest report from FINRA, margin debt ranges have surged as bullish buyers leverage their bets within the fairness market. The rise in leverage isn’t a surprise, because it represents elevated risk-taking by buyers within the inventory market.

We , within the quick time period, mirror investor optimism. In different phrases, as costs improve, buyers rationalize why paying extra for present earnings is rational.

“Valuation metrics are simply that – a measure of present valuation. Extra importantly, when valuation metrics are extreme, it’s a higher measure of ‘investor psychology’ and the manifestation of the ‘larger idiot concept.’ As proven, there’s a excessive correlation between our composite shopper confidence index and trailing 1-year valuations.”

The identical holds for margin debt. Unsurprisingly, as shopper confidence improves, so does the speculative demand for equities. As inventory markets enhance, the “concern of lacking out” turns into extra prevalent. Such boosts demand for equities, and as costs rise, buyers tackle extra danger by including leverage.

Including to that exuberance is the elevated demand for share repurchases, which has been a major supply of “shopping for” since 2000.

As CEO confidence improves, a byproduct of elevated shopper confidence, they improve the demand for share repurchases. As buybacks enhance asset costs, buyers tackle extra leverage and improve publicity as a digital spiral develops.

Nonetheless, ought to buyers be afraid of rising margin debt?

A Byproduct Of Exuberance

Earlier than we dig additional into what margin debt tells us, let’s start with the place we’re at present. There may be clear proof that buyers are as soon as once more extremely exuberant.

The “Concern Greed” index under differs from the CNN measure in that our mannequin measures positioning out there by how a lot skilled and retail buyers are uncovered to fairness danger.

At the moment, that publicity is at ranges related to buyers being “all in” the fairness “pool.”

As Howard Marks famous in a December 2020 Bloomberg interview:

“Concern of lacking out has taken over from the concern of dropping cash. If individuals are risk-tolerant and afraid of being out of the market, they purchase aggressively, by which case you possibly can’t discover any bargains.

That’s the place we at the moment are. That’s what the Fed engineered by placing charges at zero…we’re again to the place we have been a yr in the past—uncertainty, potential returns which can be even decrease than they have been a yr in the past, and better asset costs than a yr in the past.

Individuals are again to having to tackle extra danger to get return. At Oaktree, we’re again to a cautious strategy. This isn’t the type of setting in which you’d be shopping for with each fingers.

The possible returns are low on the whole lot.”

In fact, in 2021, that market continued its low volatility grind greater as buyers took on growing margin debt ranges to chase greater equities. Nonetheless, that is the essential level about margin debt.

Margin debt shouldn’t be a technical indicator for buying and selling markets. What it represents is the quantity of hypothesis occurring out there. In different phrases, margin debt is the “gasoline,” which drives markets greater because the leverage offers for the extra buying energy of belongings. Nonetheless, leverage additionally works in reverse, because it provides the accelerant for extra vital declines as lenders “pressure” the sale of belongings to cowl credit score traces with out regard to the borrower’s place.

The final sentence is crucial. The problem with margin debt is that the unwinding of leverage is NOT on the investor’s discretion. That course of is on the discretion of the broker-dealers that prolonged that leverage within the first place.

(In different phrases, when you don’t promote to cowl, the broker-dealer will do it for you.) When lenders concern they could not recoup their credit score traces, they pressure the borrower to place in additional cash or promote belongings to cowl the debt. The issue is that “margin calls” typically occur concurrently, as falling asset costs impression all lenders concurrently.

Margin debt is NOT a problem – till it’s.

As proven, Howard was ultimately proper. In 2022, the decline worn out all the earlier yr’s features after which some.

So, the place are we at present?

Margin Debt Confirms The Exuberance

As famous, margin debt helps the advance when markets are rising and buyers are taking up extra leverage to extend shopping for energy. Subsequently, the latest rise in margin debt is unsurprising as investor exuberance climbs.

The chart exhibits the connection between money balances and the market. I’ve inverted free money balances, so the connection between will increase in margin debt and the market is healthier represented. (Free money balances are the distinction between margin balances much less money and credit score balances in margin accounts.)

Be aware that throughout the 1987 correction, the 2015-2016 “Brexit/Taper Tantrum,” the 2018 “Charge Hike Mistake,” and the “COVID Dip,” the market by no means broke its uptrend, AND money balances by no means turned optimistic.

Each a break of the rising bullish pattern and optimistic free money balances have been the 2000 and 2008 bear market hallmarks. With unfavourable money balances shy of one other all-time excessive, the subsequent downturn may very well be one other “correction.” Nonetheless, if, or when, the long-term bullish pattern is damaged, the unwinding of margin debt will add “gas to the fireplace.”

Whereas the rapid response to this evaluation can be, “However Lance, margin debt isn’t as excessive because it was beforehand,” there are lots of variations between right now and 2021. The dearth of stimulus funds, zero rates of interest, and $120 billion in month-to-month “Quantitative Easing” are just some. Nonetheless, some obvious similarities exist, together with the surge in unfavourable money balances and excessive deviations from long-term means.

Within the quick time period, exuberance is infectious. The extra the market rallies, the extra danger buyers wish to tackle. The problem with margin debt is that when an occasion ultimately happens, it creates a rush to liquidate holdings. Since margin debt is a perform of the worth of the underlying “collateral,” the compelled sale of belongings will scale back the worth of the collateral. The decline in worth then triggers additional margin calls, triggering extra promoting, forcing extra margin calls, and so forth.

Margin debt ranges, like valuations, will not be helpful as a market-timing machine. Nonetheless, they’re a beneficial indicator of market exuberance.

Whereas it might “really feel” just like the market “simply gained’t go down,” it’s price remembering Warren Buffett’s sage phrases.

“The market is so much like intercourse, it feels finest on the finish.”