Tuesday, December 9, 2008

Margin Debt Tumbles

When the stock market rises, investors buy stocks on margin (i.e. borrow money to invest) in an attempt to get as vested as possible in the market in order to profit from its expected rise. At times like these, however, margin calls (i.e. requirements to pay back debts) cause investors to have to liquidate their margin positions. Here's a chart showing NYSE margin debt over the last year up to October of this year:

As far as indicators go, it does not appear as though investor sentiment can get much worse. This pattern is nothing new, however. When we looked at margin borrowing in the last recession, we saw a similar pattern to this one. This doesn't necessarily mean we're at a stock market bottom, but it does indicate that the worst of the selling may be over. After all, if there isn't much margin debt left, it can't drop by all that much.

Margin debt may be considered useful as a contrarian indicator for those who like to buy when others are fearful, and sell when others are greedy. For such contrarians, this indicator suggests now is a time to buy.


Jalalabadi said...

Isnt margin debt just a function of the whole market? If market capitalization is at $400 billion you will see margin debt limits of $400 billion, lets assume investors borrown 25% on that therefore overall margin debt would be $100 b. When the market is at $200 billion, margin limit would be $200 billion and assuming the rate of borrowing remains the same margin debt would be $50 billion.

We need to isolate margins from the stock market level. In June 2007, the S&p was at 1540. so ratio of margin debt to s&p = .25 (380k/1540). Currently the s&p is at 890 so the ratio is .27 (240k/890). it seems like the level has actually increased -- though it isnt statistically significant.

Jalalabadi said...

what is interesting however is that the current debt level is higher than that of 2006. Given that the market is significantly below 2006 levels, this may be indicative of an over leveraged position. and you cant interpret that as both a bullish (in terms of sentiment) and bearish (in terms of margin selling) signal.

Saj Karsan said...

Interesting comments, Jalalabadi. I think you're making an inherent assumption, however, that margin percentages remain constant, whereas in actuality margin percentages (for those who use margin, which is only a subset of investors) fluctuate depending on investor sentiment.

Also, when you make comparisons of today's market prices, keep in mind that this data is from October, while November likely saw a further large dip in margin use.

Jalalabadi said...

true I am making that assumption. But I dont think the assumption is faulty. say x% of investors use margin debt. And they dont take 100% margin, they take y% margin. Therefore, total margin = xy%. I am assuming that neither x nor y changes. If we take october's prices, I dont think we'd draw a dramatically different conclusion.

Saj Karsan said...

Hi J,

I would argue that both x and y fluctuate dramatically. "Y" because of more stringent requirements from lenders, and "X" because investor sentiment is altered dramatically depending on whether the economy is hot or cold.