Margin debt as a percent of nominal GDP is one of the most useful tools for monitoring leverage and excesses in the stock market. Margin debt represents the amount of money borrowed by investors to buy stocks on margin, and it has mattered historically for two reasons. First, it’s a measurable indication of the public’s appetite for risk and the degree of speculation in the equity market. Second, it represents “hot money” – or the funds that will head for the exit quickly at the earliest sign of trouble or when margin calls hit and leveraged positions must be sold. As such, when margin debt is advancing alongside the stock market, it typically means that investor psychology is supportive and that the bull market has further to run. Conversely, distinct downturns in this measure have historically tended to precede or coincide with peaks in the equity market (see graph below).
The level and trend in margin debt is very important, but so is its rate of change. Parabolic rises in this measure inherently accompany periods of strong returns; yet they are also indicative of a high degree of equity market risk and have thus historically preceded major bear markets. However, it is only a steep decline in margin debt which signals that a market top is likely in place, as many speculators are likely being forced to unwind their leveraged positions. Watch this indicator to gauge the amount of leverage in the equity market as a reliable warning flag of a market top.
Margin debt is released by FINRA between the 10th and the 25th of each month, with data for the month prior. The graph below is usually updated within 24 hours after release.
A Deeper Dive: Margin Debt Carry Load
Even when adjusting the level of Margin Debt for GDP, it can still be difficult to view the entire historical context due to fluctuating margin rates. To account for this, we also look at the Margin Debt Carry Load by multiplying margin debt by an estimated margin rate (the major bank prime rate as reported by the Federal Reserve plus 2%). The result gives us a conservative estimate of the actual cost to maintain margin, which we look at as a percent of GDP.
Large multi-year increases in margin debt, especially in the face of high borrowing costs, often precede major market tops. The largest peaks in this indicator accompanied the 2000 Tech Bubble and the Great Financial Crisis in 2007. When an upward trend reverses, it can be swift and impactful. Once margin debt and investor speculation start to unwind it is like a snowball rolling downhill, gathering speed and momentum causing the downward path to accelerate.