Tuesday, March 20, 2007

Margin debt and the stock market

Barry Ritholtz mentions over at SeekingAlpha that "NYSE Margin Hits All Time High" and comments that "It's borrowed money - not margin data - that matters" in reference to the fact that borrowing of stock for shorting purposes is not included in the number he is referring to. A linked chart of margin debt looks like this:

One item from the Wikipedia entry on the stock market crash of 1929 states "The crash followed a speculative boom that had taken hold in the late 1920s, which had led millions of Americans to invest heavily in the stock market, a significant number even borrowing money to buy more stock. By August 1929, brokers were routinely lending small investors more than 2/3 of the face value of the stocks they were buying." Granted, conditions now are not precisely the same as in 1929, but I agree that we are in "uh-oh" territory.

TheStreet.com has some commentary on margin debt. A good statement is this: "One of the things that margin does is accelerate moves in the market in either direction. When the level of margin swells, as it did late last year and early this year, the market is getting a huge dose of liquidity. Usually that makes for a higher stock market. And when margin goes down, that liquidity is being taken away." It is fairly obvious that margin would accelerate market moves because as prices go up an investor has more collateral to borrow against and can so borrow more to purchase more stock. Conversely, as prices drop, the stock collateral shrinks, margin calls are made, and the investor must sell stock to meet the margin calls.

A counterintuitive statement to me is the idea that "margin...over the long term tends to trend up." After considering it, it makes sense in that the money supply increases over time and therefore investment banks have more to lend as margin.

Finally "Margin, then, tells us not just how enthused or unenthused investors are, but something about the kind of capital constraints they're facing. When margin contracts, it indicates that people are feeling pinched, and that there is not as much money in general coming into the market." So margin levels could be a useful indicator to examine when considering where the market is going. Here is a chart that TheStreet.com provided:
The year on year growth levels in margin debt are remarkable. It seems to suggest that a large chunk of the stock market's valuation is being supported by borrowed funds. If there had been significant margin calls, one would expect to see some years where there were significant negative growth in margin debt. Seems like we're still building a house of cards.

No comments: