Saturday, November 04, 2006

Stock Market Margin Debt: An Indicator That Hasn't Lost Its Value for Investors

One of the best indicators of speculative sentiment among investors is margin debt. This doesn't measure what participants think will happen in the market; it assesses their actual commitments to the market. A sharp rise in margin debt means that investors are eager to get into stocks. A sharp contraction in debt suggests that investors are loathe to commit funds. When all the speculative money has piled into stocks--or has pulled out--what will sustain future rises or declines? It's for this reason that margin debt is a consummate contrary indicator.

Let's check the historical track record:

* During the large market drop in 1970, margin debt plunged year over year by over 35%

* With the market recovery in 1972, debt had risen by over 50%.

* During the large market drop in 1974, margin debt fell by 30%.

* By the market's recovery early in 1977, margin debt rose by over 50%.

* During the 1982 market decline, debt fell by over 22%.

* By the market peak in 1987, market debt had risen over 30%.

* With the 1987 crash, debt dropped by over 25% in 1988.

* Margin debt was slow to recover after that crash and rose only 8% by 1989.

* With the 1990 drop, debt dropped by nearly 20%.

* By early 1994, speculators were back and margin debt was up by 40%.

* Speculators were reluctant to leave the market and, by late 1994, margin debt was down only about 4%.

* With the market's speculative binge in 2000, margin debt had risen by 90%.

* The ensuing crash in tech stocks took margin debt down over 40% by 2001 and cut total margin debt in half from 2000 peaks by 2002.

* Since that drop, we saw a year-over-year peak in margin debt change of over 30% in early 2004 and over 20% in 2006, although we are not yet at the 2000 level of margin debt.

In my next post, I'll see if some guidance for long-term investment can be gained from the margin debt figures.

In the interim, several conclusions stand out:

1) Spikes in annual changes in margin debt have been associated with market tops.

2) Large declines in annual changes of margin debt have been associated with most major market bottoms.

3) Speculators have been relatively slow to jump on board the stock market following the drop of 2000-2002. In that sense, the response to the decline has been similar to the response following the drop of 1987 and, to a lesser degree, 1970 and 1974. Large bear markets appear to affect the behavior of speculators over the next business cycle.

Interestingly, margin debt is below the levels recorded in May, despite the market's recent rise. Year over year, we're up about 9% in margin debt, down from the 2006 peak of over 24%. It is hard to believe this bull swing will have legs if it continues to fail to attract speculative interest. If history is a guide, it will take a significant year-over-year drop in margin debt to usher in a cyclical market bottom.