The Market Could Begin Correcting When This 1 Thing Happens

The Market Could Begin Correcting When This 1 Thing Happens

In the short term, the stock market is wildly unpredictable. But when you zoom out, you find it’s quite cyclical. The late British banker and fund manager Sir John Templeton described it best: “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

If you’re relatively new to stock investing, this year has probably felt like the sky is falling. But like this periods happen fairly regularly. In fact, the stock market declines approximately:

  • 5% every seven months
  • 10% every two years
  • 20% or more every seven years

Those 20% declines almost always occur right after periods of extreme euphoria when greed takes over the market, and investors abandon fundamentals and caution in pursuit of huge gains. There’s one data point that is a strong indicator of a euphoric market: margin debt.

Person wearing headphones analyzes a financial graph on a smart phone.

Image source: Getty Images.

Let’s compare today’s margin debt to past bear markets to see what likely needs to happen before the market begins to correct.

Margin is a double-edged sword

Margin is money your brokerage firm loans you to increase your purchasing power. It can amplify your gains but also your losses.

When the market enters a stage of euphoria, margin debt levels tend to surge. This creates a very fragile market because of one very unpleasant caveat to investing on margin: margin calls.

When you borrow cash from your brokerage to increase your purchasing power, you give up your freedom to choose what to do with your investments if stocks decline. If the value of the stocks you bought on margin dips below your outstanding margin balance, your brokerage firm can actually force you to sell other positions to cover your debt. This is known as a margin call, and it has the power to bring a euphoric stock market to its knees.

Margin levels surge before a crash

One of the greatest indicators of a coming market crash is a surge in margin debt levels. As fear of missing out takes over, investors are willing to take on more and more risk to get rich quickly.

But the higher the margin levels climb, the more fragile the market becomes. A small dip in prices can spark a series of margin calls that ultimately crash the entire market.

When looking at both the Dot.com crash of 2000 and the 2008 financial crisis, we see that margin surged prior to both crashes.

Dot.com bubble:

1998-2000

Margin levels surge 116%

2000-2002

S&P 500 crashes 40%

September 2002

Margin levels bottom (-55%)

2002-2006

S&P 500 gains 70%

Data Source: FINRA. Table by author.

The Great 2008 Financial Crisis:

2005-2007

Margin levels surge 91%

2007-2009

S&P 500 crashes 50%

February 2009

Margin levels bottom (-54%)

2009-2013

S&P 500 gains 150%

Data Source: FINRA. Table by author.

As you can see from the data above, in both cases, the margin levels surged over 90% before promptly entering a bear market. You’ll also notice that margin levels shrunk by at least 50% before the S&P500 began recovering.

^SPX Chart

^SPX data by YCharts.

From 2020-2021, margin levels surged 95%; unsurprisingly, the market crashed in 2022.

FINRA Margin Debt Chart

FINRA Margin Debt data by YCharts.

While margin decline is not a perfect indicator of a market bottom, a 50% drop took place before the market recovered from the two biggest crashes of the last three decades (not counting the current crash). Most importantly, the receding margin indicates that the market is exiting the euphoria stage.

The question is, where are we on the road to recovery?

Margin levels have declined but maybe not enough

Based on the most recent data from the Financial Industry Regulatory Authority (FINRA), margin debt has dropped 27% from its peak in October 2021. While this is a good sign of a healing market, it might also mean more pain ahead before the market bottoms, given that the last two major crashes saw margin decline nearly double that amount.

However, it’s important to remember that just because margin debt crashed 50% in 2000 and 2008 doesn’t mean it will do the same this time. Plenty of macroeconomic factors unique to this recent crash will certainly impact how far stocks fall before the market begins recovering.

Don’t try to time the market

Studying macroeconomic metrics like margin debt levels can help make sense of a volatile market but, ultimately, shouldn’t stop you from putting your money to work. While margin almost always surges right before a market crash, there are other times it’s increased rapidly, and the market has continued to go higher. Margin levels are worth keeping an eye on as we try to claw out of the bearish period, but they shouldn’t be used to try and time the market.

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