Market analysts are becoming increasingly concerned about current levels of margin debt, the Wall Street Journal reports. These loans that use stocks as collateral tend to accelerate market downturns, since borrowers typically are forced to sell when share prices fall. In the U.S., margin debt is at more than three times the level recorded before the 2008 financial crisis began, and is even greater than its peak in 2000 before the dotcom crash, according to research released last week from the Bank for International Settlements (BIS), the Journal indicates.
The S&P 500 Index (SPX) has risen from its low of 667 on March 9, 2009 to just shy of 2,500 at Monday's open, a stunning increase of 275%. The Dow Jones Industrial Average (DJIA) has advanced an equally breathtaking 246% from its low of 6,443 on March 6, 2009 to Monday's opening value of 22,320.
Rising Tide of Debt
The value of margin debt relative to total stock market capitalization in the U.S. has been fairly constant at about 2.12% during the last four years, per BIS data cited by the Journal. The BIS is a financial institution based in Switzerland, promoting cooperation among central banks around the globe, and often described as the central bank for central banks.
However, the recent stability in this ratio can be deceptive. The absolute value of margin debt carried by investors in the U.S. has risen sharply over the past six years, from $8 billion in November 2011 to $256 billion in July 2017, according to the same sources. Soaring share prices have kept the ratio down, masking the explosion of lending. By contrast, the peak before the financial crisis of 2008 was $79 billion in June 2007. During the dotcom bubble, margin debt topped out at $214 billion in March 2000.
Additionally, the current value of the ratio is above its previous high of 2.05% recorded during the dotcom bubble. This is yet another indicator of unduly frothy markets to bearish analysts. (For more, see also: Stocks Face "Nasty Shock" From Fed-Created Bubble.)
When the price of shares securing a margin loan drops, that may precipitate a margin call. This is a demand for the deposit of additional securities or cash, to bring the value of the collateral up to the required percentage of the loan amount. Frequently, a margin call forces a highly leveraged investor to sell the shares acquired with the loan.
In a general market pullback that sparks widespread margin selling, further downward pressure is exerted on share prices. This creates a vicious circle that magnifies the market decline. Meanwhile, historically high levels of indebtedness in general, not just margin loans, are major concerns for several bearish market gurus. (For more, see also: Bear Market Ahead: What 5 Big Investors Forecast.)
In October 2007, the S&P 500 reached a value of 1,565 and the Dow 30 hit 14,918. From these pre-crisis highs, both of these indices shed 57% on the way down to their lows in March 2009. Another worrisome fact to ponder, per the IBS data presented by the Journal: the markets tumbled in 2008 and 2009 despite the fact that the sum of free credit balances in margin accounts and credit balances in cash accounts exceeded the value of margin loans during this period, meaning that there was no net margin indebtedness hanging over the markets at that time. Today's situation is all the more precarious, with the major market indices at all-time highs, and propped up by highly-levered investors.