The Margin Debt Time-Bomb

What is perhaps the greatest risk to individual investors these days?

Is it the potential for a decline in corporate earnings based on a slowing global economy?  Is it that current valuation levels in both equities and fixed income instruments are much nearer historic highs than not? Is the biggest risk a US Fed that will soon raise interest rates for the first time in close to a decade?

Although all of these are specific investment risks we face in the current cycle, my contention is that the single largest risk to investors is a risk that has been present since the beginning of what we have come to know as modern financial markets.  The single largest risk to investors is themselves.  By that, I mean the influence of human emotion and psychology in decision making.

We Are Our Own Worst Enemies

After many years of managing through market cycles, it seems pretty clear to me that humans are uniquely wired incorrectly for long-term investment success.  When asset prices double, we want those assets twice as bad. When asset prices drop in half, we want nothing to do with them. Isn’t this exactly what we saw in US residential real estate markets a decade ago?  Isn’t this what we experienced with the rise in dot-com stocks in 1999 and their demise over the three following years?  Human decision making shapes the rhythmic bull and bear market character of asset prices. We know the two most prominent emotions that drive markets higher and lower are those of fear and greed.

If we turn the clock back far enough in early human history, we know that humans ran in packs.  Strength and protection was found in a pack or herd.  It was when humans ventured away from the protection of the herd (consensus thinking) that they were physically vulnerable.  The fight or flight mechanism has been an integral part of human development over time.  Several thousands of years later, these learned decision making responses are simply hard to “turn off.”  We find comfort in decision making within the herd.  When confronted with challenge, it’s either fight or flight.  These ingrained human character traits are why we often see investors buy much nearer a top and sell close to market bottoms.  Decision making driven by emotion, as opposed to logic, is the single greatest impediment to long term investment success.  There is an old saying in the markets: “Human decision making never changes, only the wallets do.”

Human Emotions Meet Animal Spirits

Just what does this have to do with decision making in the current environment?  Remember, as investors, controlling our emotions is probably the single greatest obstacle to sound decision making.  As such, we need to anticipate potential emotional triggers so we can better confront and allay our own human responses to market outcomes.  There is probably no greater human emotional trigger than actual price volatility itself.  If we can anticipate and understand why price volatility may occur, we hope to dampen our own emotions and objectively steer through the vagaries of market cycles.

What we are seeing in the current market environment as a catalyst for potential heightened forward market price volatility is the current level of NYSE margin debt outstanding.  You may be familiar with the financial market characterization of “animal spirits.”  The concept of “animal spirits” is integrally intertwined with human emotion, in this case meaningfully heightened confidence.  There probably is no greater show of human confidence in the investment markets than borrowing to fund an investment.  Certainly, leveraged investors expect a return above their cost of capital, with expectations usually much higher than just this simple metric.  The direction and level of margin debt outstanding at any time is a reflection of these so called “animal spirits,” it is a reflection of human confidence.

The Margin Debt Time-Bomb

Let’s have a look at where we now stand.  As of July month end, NYSE margin debt outstanding stood just below a record level of $500 billion.  It hit a new all-time high right alongside the equity market itself, exactly in line with what we would expect in terms of the emotional side of human decision making.

A few observations regarding the consistent patterns of human decision making seen in the historical rhythm of margin debt are important.  First, it is clear that margin debt peaks very close to the final run to cycle highs in stocks with each bull market cycle.  Remember, when asset prices double, we as humans want them more than ever, but when prices are cut in half, we avoid them like the plague.  At the recent peak, margin debt was up just shy of $50 billion this year after being flat in all of last year.  After these near vertical historical accelerations at cycle tops, margin debt has peaked and begun to decline while stocks temporarily go on to new highs – this divergence being the tell-tale indicator equities have peaked for the cycle.   Because this data comes to us with a bit of a short-term lag, it’s seen in hindsight.  At July month end, the S&P traded above 2100, while margin debt balances fell just shy of $18 billion.  On a very short-term basis, this divergence was established in July.

Where we go ahead will now be important.  Official NYSE August margin debt levels will not be available for a number of weeks, but it’s a very good bet margin debt levels contracted again in August, perhaps noticeably.  As I watched the Dow open down over 1000 points a number of Monday’s back, it was clear margin liquidation drove the open.  Price insensitive selling dominated early trading in many an asset price gap down.

As we step back and reflect on “rational” decision-making, it would be much more appropriate (and profitable) if margin debt outstanding peaked near the bottom of each market cycle (low prices) and shrank near the top.  As long as human decision makers susceptible to emotion are involved, that is not to be.   

The final important observation germane to our current circumstances is that when market prices turn down, margin debt levels drop like a rock.  Think about leverage.  It works so well when the price of assets purchased using leverage rise.  Yet leveraged equity can be eaten alive in a declining price environment.  Forced liquidations are simply price insensitive selling.  Of course, this will only occur after prices have already dropped meaningfully enough to either force margin calls, or cause margined investors to liquidate simply in order to remain solvent or limit loss.  We have certainly seen a bit of this in recent weeks.

Why is all of this talk about margin debt important? 

In Part 2: The Criticality Of Monitoring Margin Debt Closely From Here we explore how ever higher levels of margin debt represent tomorrow’s heightened price volatility in some type of a stressed market environment, whether that be a meaningful correction or outright bear market.

Both are an eventuality, the only question is When?

Click here to read Part 2 of this report (free executive summary, enrollment required for full access)

This is a companion discussion topic for the original entry at

I couldn't agree more.  Margin debt is extremely well correlated with market performance.  I was alarmed last year after it started to decline, but it was a false alarm.
It will be really interesting to see what the updated value is when it comes out.  This is one of my four or five favorite indicators.

I'm with you, Dave & Brian, on using NYSE Margin debt as a macro down-trend confirming tool for US stocks.  For a couple of years, I've been keeping a chart of current NYSE margin total vs. its trailing 12 month average running back into the late nineties.  As Brian's charts of peaks vs S&P rises and falls suggests, it shows a high correlation that gives relatively few false signals of multi-month S&P trend changes downward.  Here's a summary of my findings:

-       There's relatively little "noise" when you're looking for changes from up-trends to downtrends.  When the current NYSE margin total has been above the trailing average for many months, as it is in a bull cycle, there have only been a total of 5 (count 'em!) breaks downward from over the TTM (Trailing Twelve Month) moving average to under the TTM avg in the last 15 years since 2000.  

-       The first was in October, 2000, right after the final September, 2000 push up which closely matched but failed to exceed the March, 2000 S&P top.  The margin total then stayed under the TTM for 2 ½ years, until March, 2003.

-       The second break under the TTM was three years later, a dip slightly under the average in August, 2006 – a single month false signal as the credit crisis was growing.

-       The third break under was in December, 2007, marking the beginning of the 2008 crash downturn.  Margin debt stayed under its TTM until the crisis had ended in July, 2009, 1 ½ years later.

-       The forth break was in August, 2011 as the European credit crisis hit stocks and moved them into a correction.  Margin debt stayed under the TTM solidly until February, 2012, and then bounced over/under as it regained footing until August, 2012, when it went above and stayed above the TTM for 2 ½ years until…

-       The fifth break under the TTM in January this year as stocks began to recoil from the end of QE.  That was another one month long break below I’m calling a false signal, though the S&P has moved sideways since, and is now below its January level.

I think there’s a reasonable likelihood that the August figure when we get it at the end of this month will show a break below the TTM once again.  As of July, current margin debt was $487 billion and my spreadsheet calculates the TTM average as $473 billion.  Based on the size of margin moves to size of market moves downward in the past, that’s within striking distance of dropping under the average.

In particular, looking at the over/under runs of this signal suggests the momentum trends that building leverage (building new credit) plays in supporting market momentum upward, and how deleveraging and unwinding credit and credit risk develops a solid run of momentum to the downside once the ball gets rolling.  

It's also worth noting that in an environment with huge ramps and declines like the 2000-2003 selloff, the 2003-2007 bull market, the 2007-2009 selloff and the bull market since, this signal could have been a very helpful corroborating risk on/risk off indicator.  However, in the August, 2011 correction, most of the damage was done before we even had the signal, so it wouldn't have been of much help except as a warning of possible increasing danger that then, in fact, didn't arrive.  That suggests that if we continue with large market cycle swings, the signal will likely continue to be useful, but will be less valuable if the market develops more a style of fast, shorter corrections and sideways movement instead of the larger cycles.  I think that a continuing the larger leveraging/deleveraging (or maybe just deleveraging :wink: swings remains a decent bet, so am keeping a close eye on this signal.

Was the false alarm caused by government agencies (including CBs) buying stock?  See China!

With EM including China selling material US T Bills and Bonds (due to $ getting stronger) that should spike interest rate.  Short of an emergency QE4 before year end, I think this could put additional pressure on the gamblers with margin debt.  Things are bit hazy because in a panic investors usually run to bonds.  Will EM sales of US bonds overwhelm that flight to safety?

thats really a debatable point! as i am not certain about which side to pick? the clock is ticking or not? whether its really a bomb or a hoax?

This is a long video but it is pretty remarkable:

In a nutshell, she's saying that the elites deliberately ruined things and there is no transparency in the USA and if people would rise up we could still overthrow the corrupt elites - but that isn't so easy, because those elites are controlling the mainstream media. Please watch it yourself - what do you think?

If I didn’t believe that there is a more important game going on than whatwe see…
…if I didn’t think that revolution is exactly one of the options the leadership WANTS
… if I didn’t see time and again that uprisings just lead to more bloodshed, but never more justice, freedom, good faith…
… if I didn’t think that the best form of fighting is tai chi, and is second only to acting in complete good faith…
…if I didn’t think that acts of war are fatally inept…
… then yes, I might think she has a point.

She isn't advocating physical violence.
Instead, she's saying that we don't have to be customers of the national banksters.

Support your local small bank, etc. My fault, i suppose, I didn't summarize it well enough.


David Stockman interview on USA Watchdog, "Financial System Booby Trapped with Debt Bombs"

Does anyone remember the Zeitgeist video?
I have been following this thing since around 2006, and got lumped into 2012, Spirituality, Mayan Calendar, etc… I guess my point is, there are literally thousands upon thousands of videos talking about these things. Throughout history, countless sages have come to show the way out of the human dreaming, but very few are interested.

The other comment talked about revolutions, and it's spot on because from what I can see, the elites draw their power from the sleeping masses. It's a subtle contract. 1 hand by itself does not a sound make. It takes participation from both sides. The masses want security, comfort, a human leader they can look up to, to solve all their problems and a God somewhere in the sky that stands ready to doom them or reward them to paradise.

I don't mean for this to be a religious discussion, but here we have billions of people worshipping religions that have committed violence against children, and murdered thousands of innocent lives in bombing plots and what have you. Regardless of the motivations and "who-dun-it" conspiracies, if people cannot question their blind obedience to such faiths, then we are pretty much stuck.

This brings me to the movie Dune, which talks of a Golden Path whose goal was to steer humanity on a future where no one could ever control anyone's lives, ever. While a noble pursuit, 99.99% of people would likely flip and freak out. So, we are going to have the Pied Pipers and lemmings around until they both fall off a cliff.

In the meantime, I feel it is incumbent upon anyone who can, to wake up by oneself, and leave the Hall of Mirrors. I don't know what lies beyond it, but from what little I know and have seen, I think it's going to be worth it. :slight_smile: