Margin debt, which is a gauge of investor confidence, is starting to rebound in 2019 after it tumbled in the fourth quarter to its lowest level since December 2017.
"As the S&P 500 drops, you’ll see margin levels drop. As it comes back, it recovers in a similar way,” explains JJ Kinahan, chief market strategist at brokerage firm TD Ameritrade Holding Corp. The market watcher notes that fluctuations in margin debt tend to be highly correlated with the broad index.
Analysts at Bank of America Merrill Lynch and other firms suggest that the fourth quarter pullback signals the stock market has reached a bottom and is positioned to make a comeback. Bulls are confident that although the market should continue to experience high volatility, similar to other recoveries following drawdowns in February 2016 and September 2011, we are not in the early stages of a more severe downdraft. While soaring margin debt would help rejuvenate the bull market, it also amplifies investor losses in the case of a sharp pullback, per the Wall Street Journal.
The Market's Rally
(% gain from December low)
- S&P 500 Index; 16.6%
- Dow Jones Industrial Average Index; 17%
- Nasdaq Composite Index; 19.6%
Margin Debt Rebounds With Market
The recent surge in margin debt is both a sign of bullishness in the market, as investors turn their backs on 2018’s risk-off environment, as well as an indicator of a sharp increase in risk facing buyers. After the S&P 500 posted its worst yearly performance in a decade in 2018, a rally at the start of the year marked the best January performance in over three decades. In Q4, investors trimmed the amount of margin debt they used to buy stocks at the fastest pace in 10 years, down $90 billion to $554.2 billion, according to the Financial Industry Regulatory Authority. Now, many Wall Street and brokerage executives indicate that loan levels have stabilized or moved higher over the last month alongside the market’s recovery.
Nick Restaino, 22-year-old investor interviewed by the WSJ, borrowed against his investments to buy shares of popular tech names such as chip maker Nvidia Corp. (NVDA) and streaming company Roku Inc. (ROKU). With cash on hand and $15,000 in borrowed money, the student roughly doubled his buying power via buying stocks and reversing short bets he made and in December. Mr. Restaino plans on purchasing more stocks through additional margin debt.
“This is an opportunity to take advantage of the large amount of margin I have,” he stated.
Mr. Restaino is one of a growing number of investors who are willing to take loans against investments that are rising in value. This strategy can amplify both gains and losses, putting investors at risk of another sharp market decline, much like Q4’s plunge. If the value of investors’ collateral drops enough, brokers can demand repayment and seize securities backing the loan if the margin call isn’t met. Investors would also then be responsible for any remaining balance.
“It’s really the indicator or the lead indicator of investor confidence in the marketplace,” said E*Trade CEO Karl Roessner. “That balance on our side has been up a little bit.”
Investors have become less cautious due to a myriad of factors including paused U.S. trade negotiations, less hawkish comments from the Fed regarding rate hikes, more attractive valuations and strong corporate profits. Injecting the market with more buying power should help boost stocks further as the S&P 500 remains nearly 7% off its September highs. However, many Wall Street analysts view the market as vulnerable to the same risks as 2018, including slowing global economic growth, particularly in China, unresolved U.S.-China trade tensions, and other macro- headwinds.
It’s important to note that while some investors may reap rich profits, the long line of investors unprepared for a steep market decline could experience disproportionately large losses.