Margin Debt

Could margin debt, or stock market leverage, be the holy grail for forecasting the trajectory of asset prices? 

So margin leverage entails investors using their existing cash or security position as collateral to increase their purchasing power in financial markets.

Put simply, margin leverage gives investors a bigger bang for their buck.

Margin debt and investor optimism peak simultaneously

So when leverage debt is at its apex, optimism peaks, bearing in mind investors’ pursuit of profits, greed lures investors into borrowing, leveraging their investment.

Conversely, when margin debt collapses, contrarian investors view this as bullish

Margin Debt

A recent piece in Wolf Street, entitled, “Market Debt Drops Further amid Imploded & Broad Stock Market Sell-Off: Not a Good Sign for stocks,” highlights the extent of declining margin debt.

The crux of Wolf Steet’s piece is that increasing amounts of stock market leverage, or margin debt, provides new fuel for the market. 

But, decreasing the amount of leverage also removes that fuel.

So the S&P 500 peaked on January 3, which was then followed by a sharp sell-off, and in the last three months is down 11.56%. 

Investors cut margin debt by $80 billion, or 8.8%, in January, which was the highest dollar drop ever, and one of the highest percentage drops ever

But Margin debt is just one variable in the stock market leverage equation.

There are other types of market leveraged methods used by institutional investors, such as Securities Based Lending (SBL). Hedge funds, professional investors that engage in speculation using credit or borrowed capital, leverage at the institutional level. 

Moreover, there is leverage associated with options, including equities-based derivatives, etc.

Nobody knows, or those that do will not reveal, the immense size of leverage bets in the financial markets today. Even banks and brokers funding this leverage are not aware of the extent of the total leverage in the system, or even how much leverage their client has.

So a steep correction, not even a crash could trigger the mother of all margin calls.

Margin calls could trigger a stock market crash where everything gets sold, including safe-haven assets to raise liquidity for margin calls. 

There could be a potential stock market crash if central banks tighten to tackle inflation, and based on the fact that markets are highly leveraged, the next crash could collapse pension funds. 

There could be no place to hide in the coming crash because everything will get liquidated, even defensive assets to meet margin calls 

We don’t buy the commodity supercycle view.

Commodity prices typically peak when war breaks out, which is unfolding in Europe. The bond bubble is already bursting, as the inflation surges lashes $11 trillion US dollars from the world’s negative-yielding debt.

Stocks are looking fragile near price support levels. 

So if central banks continue with their hawkish stance, the next 2022 crash could be the historic global crash of everything there will be no safe place to hide. 

The outperforming investor could be the one that experiences less wealth erosion. US dollars could be king for a short period as bald eagle investors pounce on distressed global assets. 

Declining margin debt, collapsing investor, consumer, and business sentiment, the inverted US 2s/10s treasury yield curve, and war in Europe are flagging a global depression and imminent historic stock market crash. Will the pin, central bank hawkish policy burst the bubble of everything, or will monetary policy revert to being Dovish with more easing, money printing?

Fortunes will be made or lost by getting this bet right.

The Fed is likely to choose the path of least resistance. 

Why would they blow up their debt system and bankrupt their best customer, the government, for their product, debt? 

Imagine if emergency public workers’ cheques bounced and unpaid pensioners played out, then that would be a mad max scenario.

So investors might see no reason to sell and instead, front-run the next easing cycle. 

Many of the high-flying stocks have collapsed by 60%, 70%, and even over 90%, and the NASDAQ, technology-heavy index is down almost 15% year to date. 

But what if the Fed decides to prick the bubble of everything, which it created, and continue tightening into the great reset?

Despite margin debt heading south with all other indicators, the decision to slay the bull market is entirely down to what the central banks decide to do, and it is a political decision.

So for the BTFD crowd that interprets declining margin debt of 8.8% as bullish, here are the higher percentage drops.

  • Covid crash (March 2020: -12.1%);
  • Euro Debt Crisis (August 2011: -10.4%);
  • Financial Crisis (May 2010: -9.1%, November 2008: -18.1%, October 2008: -19.7%, August 2007: -13.0%);
  • Dotcom crash (March 2001: -12.1%; December 2000: -11.6%; April 2000: -10.4%.)

Despite declining margin debt, history is on the bull’s side

But since nobody knows what the Fed will do next, there is even discord amongst the Fed committee about whether to remain hawkish or return to being Dovish, perhaps the 60-40 portfolio might be the safe play.

But 60% of the portfolio is in cash, king dollars. 

Yes, cash is trash, even more so as core inflation is above 8%, but at least investors are losing the least by holding USD, and if and when the SHTF, they will be the fortunate ones able to swoop on distressed assets like bald eagles.


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