While many think the market will continue its current upward trajectory, margin debt is nearly as high as it was in 2007, which could lead to a sudden, and prolonged, drop in stocks.
“A man who both spends and saves money is the happiest man, because he has both enjoyments.”
On April 23, there was a sharp fall in the market (see below). The cause of the precipitous drop and quick recovery of the S&P 500 was a bogus tweet from a hi-jacked Associated Press account. It indicated that President Obama had suffered injuries from explosives that were detonated at the White House.
The ruse was quickly squelched and the market recovered.
From The Washington Post Blog.
Some think this deep dive could happen again and last longer — months or years instead of minutes. The instigator, as they see it, is the recent high level of margin (use of borrowed money to buy securities) in the market. The source of the borrowed cash is from one’s brokerage firm. Officially, the practice is called, “buying on margin.”
This is what is alarming to these market watchers. Margin debt is nearly as high as it was in 2007. Then, it was $381 billion. As of March 2013, it hovers at $380 billion. To some, this indicates that investors, gaining confidence because the market is rising, are willing to take more risk by borrowing money from their broker to invest more. As long as the market rises, this strategy works.
However, when the market falls the debtors have to pay back their margin using ready cash, which many don’t have. Thereby, to cover the margin debt, they are required to sell their stock and the market falls.
This starts a vicious cycle that affects all investors (even though they aren’t on margin) because when the market drops quickly, emotions run high and even individuals in the market for the long term tend to flee.
Margin debt predicted a market drop for the S&P 500 two times in the recent past, once in 2000 and again in 2007 (see figure above). This historical evidence suggests to a cautious investor that taking some money off the table now might be prudent even though many think the market will continue its upward trajectory as long as the government continues to pump money into the economy.
What path to take in the stock market is rarely crystal clear and this situation is a perfect example. Still, for those that are worried about the frothy level of the S&P, the high level of debt margin and other worrying U.S. and global conditions, taking money off the table might improve their comfort levels. The problem, of course, is what to do with cash now. Though re-investing it is always an option (one idea here), there is another.
Spend it. Money is, after all, not only meant to be earned, invested well and grown. It is also intended to be enjoyed. That is, provided funds for retirement, future education, etc., have been secured.