• Eng Guan

Margin Debt Levels - What Does It Tell Us

We all know what debts are. And there are many different types - mortgages, auto loans, student loans, credit card debts, personal loans, and more. These are household debts. Then there are also corporate debts and government debts. In aggregate, they give you a snapshot of the current health of the economy. But besides these, as investors, margin debt is something you should know as well.


What is Margin Debt?


When you open a brokerage account, many offer you the option of a cash account or a margin account. With a cash account, you need to pay for any securities you buy in full. But with a margin account, you can borrow from the broker to buy securities beyond what you hold in the account. Similarly, when you short sell securities, you need to post margins against the borrowed stocks as well. If you do not have enough in your account, then you need to borrow from the broker. And the amount you borrowed is the margin debt.


The level of margin debt since 1997


The level of margin debt in the US tends to grow and wane along with the market cycles. FINRA tracks the margin debt every month across its member brokers and dealers in the US. And they released the data on the third week following the end of each month.


US margin debt hit a record of $935 billion in October 2021 before falling to $799 billion as of end-March 2022 as investors deleveraged in response to heightened uncertainties with stagflation fears and an aggressive rate hike cycle. But even then, our margin debt today is still much higher than it was back in 2007 before the Great Financial Crisis. To get a sense, the peak of the margin debt levels in 2007 was just $416 billion. An extended period of low-interest rates and loose money printing by the central banks plays a crucial role in where we are today.


Margin debt tends to peak before the stock market

The level of margin debt vs S&P 500 (1997-2022)
The level of margin debt vs S&P 500 (1997-2022, Data Source: FINRA)
Margin Debt & Stock Market Peaks
Margin Debt & Stock Market Peaks

What may be of interest though is that margin debt tends to peak, anywhere from 0 to 6 months, before the stock market prior to major pullbacks or corrections. But of course, just like all charts, the peaks are easy to spot in hindsight. In reality, it is much harder to ascertain if the levels have indeed peaked until months later.


Why does this happen?

Without specific details of the trade flows, we cannot be sure. But we can try to think about this sensibly. Financial institutions such as hedge funds and prop trading firms are among the ones that use the most leverage. When market uncertainty surges, these guys are often also the first to deleverage. They do that to reduce the risk exposure they have to the market.


These days, there are many funds that manage their risk by maintaining a target risk level for their portfolio. So if the market becomes volatile, they deleverage to bring the portfolio risk down to their target. Conversely, if the market calms down and the risk subsides, they leverage up to bring the portfolio risk back up again to their target.


But not all market participants adopt the same approach. There will always be buyers, both institutions and retail. Some are hunting for bargains. Some are doing dollar-cost averaging. Some may just be buying on dips with little research. Others are deploying fresh funds that came in. There are many reasons. Institutions also tend to spread out their selling over time so as to minimize the impact on the market. If you want to sell your securities at a good price, the last thing you want is to spark a panic market sell-off by offloading huge chunks of your portfolio into the market. So it can potentially take some time before buyer interests weaken or selling overwhelms and prices head south.


The level of leverage since 1997


Now, what we just looked at is the absolute margin debt levels in dollars and cents. Given how the market has grown and how much money is circulating in the system today, some may argue that it is not objective to just look at margin debt in isolation. To get a fuller picture, we can focus on the amount of margin debt we have over the cash balance in the accounts.

Margin Debt / Cash vs S&P 500 (1997-2022)
Margin Debt / Cash vs S&P 500 (1997-2022, Data Source: FINRA)

A margin debt/cash of 1 means for every $1 of margin debt, there is $1 of free cash sitting in the accounts. If this number is lower than 1, that means we have more free cash than debt. And if it is more than 1, then it means the reverse.


The margin debt/cash levels rose steadily after the Great Financial Crisis (GFC) in 2007-2008. There are several ups and downs with a decline starting at the end of 2018. And it bottomed only after the worst months of the Covid-19 pandemic in February and March of 2020. Thereafter, it increases rapidly until reaching a peak of 2.19 in October 2021. This is higher than both the levels before the 2000 Dot Com Crash (margin debt/cash 1.85) and the 2007-08 GFC (margin debt/cash 1.17). Again, this is not surprising given over a decade of easy money policy. And if you are wondering why such a relatively low level of margin debt/cash can trigger something as severe as GFC, that is because we are only looking at margin debt here. It's only a slice of the full debt picture. Household, corporate, and government debts are missing here.


As you can see from the chart, the margin debt/cash plot has more discernible peaks. But that actually makes it more challenging to visually match them against the stock market peaks. But the general observation is the same, the margin debt/cash peaks tend to occur before the stock market peaks.


Now, while this information can be useful for an economist or a discretionary trader to make sense of the broader market moves, its value from a quantitative perspective is limited. Because there are simply too few occurrences to statistically validate its value and to structure any strategies around it.

 
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