If it bleeds, it leads. ~Joe Loder in Nightcrawler
Margin debt recently hit an all-time high—$528 billion as of February month end. But, by another measure, margin debt divided by underlying assets, it’s actually at a lower level than it was in February 2009—the start of the market recovery from the global financial crises.
So, how concerned should you be about margin debt? What does it tell us about the market going forward and how much attention should you pay to these attention-grabbing headlines?
In the 2014 film Nightcrawler, Lou Bloom (played by Jake Gyllenhaal) is a down and out thief turned “Stringer” (a freelance photojournalists) through whom the movie explores what Wikipedia calls “the symbiotic relationship between unethical journalism and consumer demand” or, better known as, “If it bleeds, it leads.”
The demand for gloomy or sensational headlines can be explained by our negativity bias, something the media is very adept at exploiting to their advantage. Here is Peter Diamandis, the Chairman & CEO of the X Prize Foundation, in an interview on the topic (emphasis is mine):
The amygdala is our danger detector. It’s our early warning system. It literally combs through all of the sensory input looking for any kind of a danger…and it evolved during an era of human evolution that was of the immediate type, the tiger in the bush. You would hear a rustle in the leaves and you would think tiger, not wind and the point—one percent of the time that it was a tiger it saved your life, but today the amygdala literally calls our attention to all the negative stories and if you see a thousand stories you’re going to focus on the negative ones and the media takes advantage of this and you know the old saw if it bleeds it leads. Well that’s why 90% of the news in the newspaper and on television is negative because that’s what we pay attention to.
So then, it’s no surprise then that this same demand for negative news is also seen in the financial media. Which brings us to one of the scary headlines du jour: MARGIN DEBT. Recently, the Wall Street Journal ran a piece highlighting the fact that margin debt hit record levels with the title proclaiming “Margin Debt Hit All-Time High in February.” From the article we learn:
The amount investors borrowed against their brokerage accounts climbed to $528.2 billion in February, according to the most recent data available from the New York Stock Exchange, released Wednesday. That is up 2.9% from $513.3 billion in January, which had been the first margin debt record in nearly two years.
Later, the article includes the scary comparison to the tech bubble and global financial crises.
But experts say a steep rise can indicate that investors are losing sight of market risks and betting that stocks can only go up. Margin debt has a history of peaking right before financial collapses like the ones in 2000 and 2008. When stocks move lower, investors who are buying with borrowed money often must pull out of the market, exacerbating the decline.
However, what they leave out is that margin debt is going to ebb and flow with the market. It's normal for margin debt to increase over time as the market increases in value. Take another type of debt as an example: mortgage debt. Imagine, for your first home, borrowing 80% on a $200,000 house leaving you with a mortgage $160,000. A decade and a few kids later, you decide it’s time to upgrade to a bigger house. Now because home prices have increased and you’re moving to a larger house, the purchase price is $500,000. Putting the same 20% down leaves you with a mortgage of $400,000. You now have “record levels of mortgage debt,” even though, as a percent of the underlying asset (your home), you still have the same cushion (20% equity).
The same is roughly true of margin debt currently. While it doesn’t make the headline, the article does include the following line:
When measured against the rising value of the market, investors now aren’t setting records in borrowing against their accounts. Margin debt totaled 2.5% of market capitalization on the New York Stock Exchange in February, roughly level with where it was in 2013.
The bottom line is that margin debt isn't predictive of future market movements, instead, it's what is called a coincident indicator. It rises and falls with the markets, but doesn’t cause the markets to rise and fall. The following chart from Bloomberg depicts this visually (click any chart to enlarge):
And, by taking one into the other (debt divided by assets), we can see that this ratio has been fairly consistent since 2007, ranging between 200 and 250. So, while total margin debt has increased, it has not increased as a percentage of underlying assets. In fact, the current level is actually lower than it was in March 2009, the start of the market recovery from the Global Financial Crises.
There’s a lot you should worry about financially: how much you’re saving and how much can you afford to spend in retirement; taking the right level of risk with your portfolio; getting a financial plan in place; how to spend down your assets in a tax-efficient manner, and so on—but, the current levels of margin debt shouldn’t make your list.
Remember, as we’ve written before (see: “The Panic Tax”), the media exists for one reason: to make money. It’s not there to break actionable news (since someone or something will always be faster), give you profitable trading advice, or make you smarter. They simply want as many eyeballs as possible and will resort to all manner of hype necessary to get them.
"If it bleeds, it leads" may be a good strategy to sell media, but it’s the wrong place to start when it comes to making financial decisions.