Fear and greed drive markets. Borrowing money to buy shares is a good indicator of where we are in the cycle.
When the big traders, speculators and hedge funds are confident, and markets are rising, they get greedy. And unlike us normal investors, when they get greedy they don't just buy shares, they borrow lots of money to buy shares, amplifying their gains. Not surprisingly, therefore, there is a powerful correlation between these borrowing levels (called margin debt) and the trend in major indices. Margin debt is an indicator well worth watching, not just for traders but for long-term investors looking for buying and selling signals.
Amplify gains (and losses!)
Many brokers, especially in the US, allow margin accounts. In effect these allow the trader to borrow money from his broker to buy shares. The trader then has to repay the debt with interest.
An investor may borrow 50% of the investment he makes in a portfolio of shares. The broker, or regulatory authorities, then stipulate that the investor has to maintain a personal stake, of say 25% in the investment. This is known is the 'maintenance margin'.
Using these assumptions it would be possible to invest £10,000 by paying £5,000 and borrowing £5,000. If prices rises 40% (to £14,000), our lucky (skilful?) investor makes £4,000, less any interest payments. Based on his investment of £5,000 he has made a 80% return, twice the non-borrowing investor's 40%. A borrowing rate of 50% is therefore known as 2 to 1 gearing. To put this into context during the debt fuelled binge of 2007 some hedge funds were geared 30 to 1!
Margin accounts can seriously damage your wealth
In the above example, if the value of the portfolio decreased by 40% (from £10,000 to £6,000) the trader's personal stake is now only £1,000 (£6,000 - £5,000). But to maintain his stake at the agreed 25% of value (£1,500) the broker will issue a 'margin call'. Either the investor has to deposit another £500, or the broker starts selling shares to that value.
These examples show that in rising markets speculators will tend to pile on the debt to maximise gains. In falling markets they have no realistic option but to liquidate their positions and dump shares -- precisely what happened to leveraged hedge funds in 2008.
Because of the amount of money that can be won or lost, margin trades are 'high conviction' investment activity by professionals -- they should provide reasonable market indicators.
Predicting turning points in the market
Rapid declines in margin debt from peaks predicts large losses. Large reductions were seen in autumn 1987, 1988, and spring 2000. The indicator is particularly good at identifying large and savage movements because accelerating declines force more and more investors to meet margin calls, and sell stock.
Similarly, rising levels of margin debt will indicate that the big professional investors are feeling not only confident, but so confident they are taking on increasing levels of debt to invest in the market.
As an illustration, the levels of margin debt reported to the New York Stock Exchange (NYSE) from 1999 to July 2007 are shown in the table below.
|Month||Year||Margin debt ($m)|
I chose the month of July because that is when the 2007 measure peaked. From then on it started declining, leaving everyone three or four months to sell before the FTSE 100 peaked. For interest, the year 2000 figure peaked at 278,530 in March of that year, declined in subsequent months and again gave plenty of warning to avoid the worst of the falls.
The margin debt figure is currently signalling 'positive'
So what is the current margin debt figure signalling? The table below shows the level of debt the year after the peak and then monthly.
|Month||Year||Margin debt ($m)|
So, it would appear in the year to date that the professionals thought the March lows were a bear market bottom, and are slowly increasing their gearing. They are saying that this is a time to buy. Those of a more cautious disposition may wait a few months and see if the trend continues.
For those interested in tracking this indicator the NYSE publishes it every month with a two-month delay. No such statistics are available for the UK market, but the two markets are now so highly correlated that using US statistics presents no problems.
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