Margin of Error?

Investopedia defines margin debt as, “the dollar value of securities purchased on margin within an account. Margin debt carries an interest rate, and the amount of margin debt will change daily as the value of the underlying securities changes.”

Typically, the maximum of margin debt allowed is 50% of the value of an investment account or in other words, if your investment account value is at $US 100,000 you can borrow (leverage) up to a further $50,000 to invest.

If you ask just about any investor, whether they are amateur or professional, “when is the best time to buy and sell an investment,” they will answer without blinking, “buy low, sell high.” Yet, as a herd, they do the opposite as can be shown via a myriad of sentiment indicators.

Margin debt can also be used as an indicator of investor sentiment and can be used in a contrarian manner. In other words it can assist in spotting market tops and bottoms.

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Note the long term history of US margin debt, courtesy of the New York Stock Exchange, going back to 1959 and shown in red.  Notice also that the higher stocks rise, as shown by the S&P 500 index in black, the more investors borrow to invest. Likewise, as stocks bottom, they borrow less. Not quite buy low, sell high is it?

The latest figure from the NYSE for margin debt is for the end of April 2013, at $384.4BN, a new record high and surpassing the previous record high of $381.4BN seen in June 2007.

Furthermore, the record high before 2007 was in March 2000, just as the NASDAQ bubble burst. So you can see a warning pattern here.

Even more worrying is that margin debt can be a cheaper and easier way to borrow than a traditional loan, hence some advisers are recommending margin borrowing for uses like home renovation, business expansion and even “house flipping,” themselves all symptomatic to the pre-2007 bust.

We are also interested to look at margin debt as a percentage of GDP, or the size of the US economy.

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There are two observations to be made:-

  • Over the 35 years from 1959 to 1994 margin debt never exceeded 10% of GDP, until mid-1995 since when it has remained in double-digits.
  • At a near 24%, margin Debt/GDP is nearly 10 times the ratio seen at the 1974 stock-market low.

Margin of Error” is defined as, “an allowance for slight error or miscalculation, an allowance for changing circumstances.”

We may be wrong, of course, in mis-calculating the evidence. However, ongoing studies of human emotions, particularly in matters financial, place the odds on our side.

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One response to this post.

  1. […] June of this year we wrote a piece called, “Margin for Error,” commenting on what margin debt is, how it can be used as a good contrarian sentiment indicator […]

    Reply

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