It’s not an exaggeration to say investors using credit to invest in stocks and other securities is at extreme levels.
In fact, margin debt is at a record, rising at the fastest pace since 2007, and some of the charts in this story reflecting that are truly eye-popping.
Ed Yardeni, President of Yardeni Research, points out that margin debt is always closely tied to bull and bear markets.
At the moment, stocks are “melting up” as central bank and government stimulus along with investor borrowing are providing “rocket fuel” for stock prices.
But look out when the inevitable bear market comes.
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by Ed Yardeni
Margin debt can act as a great propellent of stock prices on the way up but a catalyst to disaster on the way down. I was quoted as follows in a recent WSJ article on this subject:
“It fuels bull markets and it exacerbates bear markets and to a certain extent you put it on the list of irrational exuberance,” said Edward Yardeni, president of consulting firm Yardeni Research. “The further that this stock market goes, the higher that margin debt will go, and when something blows up that will be one of the factors for why stocks are going down.”
Margin debt doesn’t trigger bear markets; it just makes them worse. Bear markets are usually triggered by credit crunches that cause recessions.
Right now, margin debt is contributing to the meltup in stock prices.
The Treasury is also providing lots of rocket fuel in the form of “relief” checks, which are also sending stock prices into outer space—or at least to new record highs.
Let’s review the latest relevant data:
(1) Margin requirement. The Securities Exchange Act of 1934 mandated federal regulation of purchasing securities on margin.
The margin requirement was motivated by the concern that credit-financed securities speculation helped fuel the run-up in stock prices prior to the stock market crash of 1929.
The Act casts the Federal Reserve as the body responsible for managing the availability of credit in the economy, so the Fed was charged with setting margin requirements for securities purchases.
The Securities Exchange Commission was directed to enforce those regulations.
The Fed has chosen to set only the initial margin requirement.
Since 1934, the Fed has changed the initial margin requirements in stocks 23 times. It has been unchanged at 50% since 1974.
The Fed’s unwillingness to use this macroprudential tool to counter the occasional bouts of irrational exuberance in the stock market was explained by a March 24, 2000 article in the FRBSF Economic Letter titled “Margin Requirements as a Policy Tool?” as follows:
“However, the effectiveness of using margin requirements as a policy tool is questionable. Investors can use financial derivatives to obtain exposure to equities without owning stocks, and they also can substitute margin credit with other types of credit.”
The maintenance margin, which determines the leverage on a continuing basis, is set by the exchanges and brokers.
In practice, the house margins set by individual brokerage firms are higher than the initial margin, and some brokerage firms further differentiate their margin requirements by individual stocks and the trading behavior of their customers.
To the extent that the maintenance margin is less than the initial margin, the price of a stock can fall substantially before investors are required to furnish additional funds.
Keep in mind that margin debt reflects both short and long positions. In addition, it includes all credit extended against any type of marginable collateral, not just equities.
This includes government and agency securities, corporate bonds, and some foreign securities.
(2) Margin debt. In any event, a series on margin debt outstanding is available monthly since January 1959.
It is highly correlated with the market capitalization of the Wilshire 5000 as well as those of the S&P 1500 and S&P 500.
Over the past 12 months through February, margin debt is up by a record $269 billion.
It is up 49.3% year-over-year, the highest growth rate since July 2007.
(3) Free advice. I think that the Fed should occasionally raise margin requirements during bull markets to at least signal when Fed officials are concerned about the potential for speculative excesses.
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