The market can start correcting when that first thing happens

In the short term, the stock market is widely unpredictable. But when you zoom out, you find that it is 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 investing in stocks, this year you’ll probably feel like the sky’s falling. But periods like this do happen fairly regularly. In fact, the stock market is almost falling:

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

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

A person wearing headphones analyzes a financial chart on a smartphone.

Image source: Getty Images.

Let’s compare today’s margin debt to previous bear markets to see what should likely happen before the market starts correcting.

Margin is a double-edged sword

edge It is the money that a brokerage firm lends to increase your purchasing power. It can magnify your gains but also your losses.

When the market enters the euphoria stage, Marginal Debt Levels tend to rise. This creates a very fragile market due to one unpleasant caveat to investing on margin: marginal calls.

When you borrow money from your brokerage firm to increase your purchasing power, you give up your freedom to choose what to do with your investments in the event that stocks go down. If the value of the shares you bought on margin falls below the outstanding margin balance, the brokerage firm can actually force you to sell other positions to cover your debts. This is known as a margin call, and it has the potential to bring the jubilant stock market to its knees.

Margin levels rise before the crash

One of the greatest signs of advent market crash Marginal debt levels are rising. With the fear of losing control, investors are willing to take more and more risks to get rich quickly.

But the higher the margin levels, the more fragile the market. A slight price drop can lead to a series of margin calls that eventually… Entire market crash.

Looking at both the Dot.com crash of 2000 and the financial crisis of 2008, we see that margin rose before both crashes.

Dotcom bubble:

1998-2000

Margin levels are up 116%

2000-2002

S&P 500 crashes 40%

September 2002

Bottom Margin Levels (-55%)

2002-2006

S&P 500 gains 70%

Data source: FINRA. Table by author.

The Great Financial Crisis of 2008:

2005-2007

Margin levels go up by 91%

2007-2009

S&P 500 crashes 50%

February 2009

Bottom Margin Levels (-54%)

2009-2013

S&P 500 gains 150%

Data source: FINRA. Table by author.

As you can see from the above data, in both cases, margin levels rose more than 90% before the immediate entry into alcohol market. You will also notice that margin levels have shrunk by at least 50% before Standard & Poor’s 500 Recovery began.

^ SPX Chart

^ SPX data by YCharts.

From 2020-2021, margin levels have increased by 95%; Unsurprisingly, the market collapsed in 2022.

FINRA . Marginal Debt Scheme

FINRA Margin Debt data by YCharts.

While a margin drop is not a perfect indicator of a market bottom, a 50% drop occurred before the market recovered from the two biggest crashes of the past three decades (not counting the current crash). More importantly, a margin dip indicates that the market is out of euphoria.

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

Margin levels are down but may not be enough

Based on the latest data from the Financial Industry Regulatory Authority (FINRA), marginal debt is down 27% from its peak in October 2021. While this is a good sign of a market recovery, it could also mean more pain ahead for market bottoms, given that the two crashes The last two majors have seen margin drop by almost double that amount.

However, it is important to remember that just because marginal debt collapsed by 50% in 2000 and 2008 does not mean that it will do the same this time. A lot of the unique macroeconomic factors of this latest crash will definitely affect How low will the stock go? before the market starts to recover.

Do not try to determine the time of the market

Studying macroeconomic metrics like margin debt levels can help you understand a volatile market, but ultimately, it shouldn’t stop you from investing your money in the business. While the margin almost always rises right before the market crashes, there are other times it increases quickly, and the market just keeps going higher. Margin levels deserve attention as we try to break out of a bearish period, but they should not be used to try to time the market.